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Free Money: Arbitrage opportunities in EM external debt

Market Commentary

14 June 2016

Conventional wisdom has it that Emerging Markets (EM) are risky. This is why EM forms a side allocation in most investors’ portfolios rather than the core component. Yet, the very fact that EM countries are perceived as risky is part of their attraction. EM bonds explicitly command a risk premium, whereas risks in Developed Markets (DM) are barely perceived and hence not priced in. Arguably, this makes DM structurally more risky than EM. Two recent developments in the global macroeconomic environment and within the EM asset class suggest that EM dollar bonds now offer arbitrage opportunities. First, EM external debt has become mispriced versus DM fixed income, probably due to the highly asymmetric effect of QE asset purchase programmes on fixed income in DM versus EM bonds. Secondly, the market does not appear to have priced in the benefit of greater diversification within the EM external debt asset class arising from the sharply increasing number of index names. We demonstrate and quantify the size of these opportunities.

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