Foreign ownership of Emerging Market local currency bonds has been on the rise since the Lehman default but has also caused the asset class to become more volatile.

The Lehman bust – and the financial crisis – forced the central banks in the developed world to keep interest rates low in order to spur economic growth. Since then, yields on developed market bonds have been falling. This created a huge inflow into higher yielding local currency Emerging Market bonds.  There was indeed a hunt for yield. 

As the asset class gained in popularity, the share of foreign holdings increased and yields were driven down. In a a very nice IMF publication - published this month - by Christian Ebeke and Yinqiu Lu ( link: IMFPaper ) they find that if the share of foreign investors in the government bond market increases by 10 percent, yields will be reduced by 0.70 to 0.90 percent.

No doubt, as an asset class gains in popularity, it will become more expensive.

But, one can argue that when a new type of investor enters the picture, the asset class may also become more volatile. The study confirms that yield volatility – in general - rise as foreign investors increase the ownership. So, as the asset class becomes more popular with foreign investors it also becomes more volatile.

So, what about macroeconomic fundamentals ? Do they play a role in this – at all ?  Yes, they do. According to the study, when Emerging Market countries run large current account deficits or have very low foreign exchange reserves, foreign ownership will increase yield volatility by much more. Conversely, in Emerging Market nations with surplus or huge foreign exchange reserve, foreign ownership can actually lower yield volatility.

This is the main point of the research: Emerging Market countries “with weak fundamentals compared to others would suffer the most from an initially high exposure to foreign investors in their domestic bond markets. Indeed, they tend to exhibit higher yield volatility suggesting that they are more prone to sudden-stops or flow reversals.”

Now, this study covers post Lehman and before discussions of US central bank tapering, so the data analyzed in the paper starts in the first quarter of 2009 and ends in the first quarter of 2013. Therefore, the effects of the tapering and the subsequent outflows and market volatility this caused are unfortunately not directly reflected in the study.

Nonetheless, the main points of Christian Ebeke and Yinqiu Lu´s study proved correct through the “market storm” that was initiated when the Fed started talking about the possibility of the central bank tapering its securities purchases back in May 2013.

The acronym “the fragile five” was invented by commentators and analysts in the fall of 2013 to cover the five Emerging Market countries running current account deficits and relying on foreign money to finance growth. You can read more about it in this NYTimesarticle. Most of the underperformance of “the fragile five” was via FX depreciations, but the local government bond market was also hit.