Chart of the day: When emerging markets trade through the G7

By Felix Salmon
May 16, 2011
Secular Outlook: the market risk spread on advanced economies now exceeds that on emerging economies.

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Thanks to Mohamed El-Erian for pointing this out in his latest Secular Outlook: the market risk spread on advanced economies now exceeds that on emerging economies.

Here’s Pimco’s explanation for what we’re seeing in this chart:

The difference in spreads shows the 5 year Markit CDX.EM.15 index minus the 5 year Markit iTraxx SovX G7 Index Spread. A positive number implies that Emerging Markets sovereign spreads are greater than Advanced Economy sovereign spreads. A negative number implies that Emerging Markets sovereign spreads are less than Advanced Economy sovereign spreads and therefore, the market implied credit risk for EM is lower when the spread is negative.

This is a very big deal, because the names in the EM.15 index are not exactly paragons of creditworthiness. Here’s the list: it starts with Argentina and Venezuela, and goes on from there, including countries like Panama, Russia, and Ukraine.

Meanwhile, the SovX G7 list is short and powerful: Germany, France, Japan, Italy, UK, and USA.

There are probably technical reasons why a group of AAA-rated sovereigns is trading wide of a group of much less creditworthy emerging markets in the CDS market. But the big message here is clear: the world is being turned upside-down. And most investors have yet to even start adjusting to these new realities.

Update: Turns out that the chart wasn’t measuring the G7 spread after all, but rather the Western Europe spread, which includes all the PIIGS.

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5 comments so far

What kind of debt actually goes into the CDX.EM index? I thought it includes corporate debt as well.

I just looked up the 5-year CDX.EM index on bloomberg (it is the 15th vintage, I think this is the same one you’re talking about) and I got 113.68. I couldn’t find the SovR index (maybe we don’t subscribe to that one). I got 36.39 for Germany, 69.48 for France, 82.05 for Japan, 145.78 for Italy, for UK, and 41.6 for US.

The only one greater than the CDX is Italy. I assume if you combine them to a portfolio, there is some correlation so that the average spread should be less than the just a weighted average of the above spreads I provide (based on the weight in the index). Similarly, if you combine a bunch of risky EM debt, you would get a lower spread than you would think since the probability of default in one country has a lower correlation to another (I’m not sure a priori whether the correlation would be higher or lower in EM vs DM markets, but the fact that there are more EM countries provides more scope for diversification).

Posted by jmh530 | Report as abusive

this blows my mind. Brazil, Russia, Argentina, etc trade tighter than US, UK, Japan, Germany? HUH?

can a sovereign debt guy explain this to me?!?!?

Posted by KidDynamite | Report as abusive

Don’t tightening spreads point to a larger story: world-wide asset deflation?

The yield on the junk-bond index recently touched a new low of 6.66%: 10/6-66-the-number-of-the-junk-bond-beas t/

And today (AA-rated?) Google issued 10-year debt 22 bps over the 10-year. (I think if Goog had waited longer, they could have issued debt *even* tighter to the curve.)

The worldwide hunt for yield, briefly interrupted by the 08-09 Winter meltdown (when principal repayment was genuinely questioned), is most certainly back-on-track.

One shouldn’t be surprised to hear talk of creating synthetic junk-bond yields. (I’m in favor of ‘em.) As long as defaults can be rolled onto sovereign balance sheets, it’s “Everyone into the pool” (of liquidity).

Posted by dedalus | Report as abusive

@jmh530, the reference obligations underlying CDX.EM are in the table linked by Felix. They all look like sovereign bonds to me.

There is no portfolio diversification effect here because we are dealing with expectations. However, the spread of basket protection (such as CDX) systematically tends to trade at a basis to the weighted average of a portfolio of single-name protection on the underliers because of survivor bias. A single spread overpays for some names and underpays for others, but the “bargains” are precisely those most likely to terminate first. However, technical factors can influence this basis strongly; even reverse the sign.

SovX G7 is a theoretical index calculated by Markit, not a traded asset. It is just the sum of the underlying spreads (equally weighted I think), not basket protection.

An exact comparison between G7 and EM would therefore require an adjustment for this basket/portfolio basis. There is also some work to be done behind the scenes because some of the EM underliers trade on 25% recoveries, and because traded US sovereign CDS pays EUR but the G7 index is USD. But I think Felix’s point is that the simple fact that G7 and EM are even roughly comparable would have been unthinkable a few years ago.

Posted by Greycap | Report as abusive

Maybe bond investors realize the U.S. is really a banana republic like all the other listed countries.

Posted by PhilPerspective | Report as abusive
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