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An Empirical Investigation into the Causes and Effects of Liquidity in Emerging

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Introduction

An Empirical Investigation into the Causes and Effects of Liquidity in Emerging Market Sovereign Bonds and US High-Yield Corporate Bonds 1. Introduction Emerging market sovereign bonds and US high-yield corporate bonds have increasingly become competing asset classes over the past decade. Investors have turned to both markets in the search for high yield following global economic slowdown and low global interest rates. One main concern investors have about both bond markets is their liquidity risk. Owing to the nature of fixed income securities, higher return is often associated with higher risk. High-yield bonds have below investment grade ratings because of the high probability of default of the country issuing the security. This means that it can be difficult to sell such assets at the correct market price and so a liquidity premium exists. This can be measured by the difference between the bid and ask prices on the bond in question. If investors are increasingly willing to hold such bonds in the wake of global economic slowdown and because of the impressive returns such asset classes achieve, it is interesting to consider if changes in liquidity in one market will affect changes in liquidity of the opposing market. Then the macroeconomic fundamentals that cause such changes to take place need to be examined. This paper uses data on average monthly bid-ask spreads1 in the JP Morgan Emerging Market Bond Index (Global) and the Merrill Lynch US High-Yield Fund Index as a measure of liquidity in order to examine the cross-liquidity effects of the two bond markets.2 A set of macroeconomic explanatory variables are used in a multivariate cointegration framework,3 in order to examine the causes of changes in liquidity of the two asset classes. The conclusions that are derived follow. There is indeed a long run, steady state relationship that exists between the two opposing asset classes, suggesting that the cross-liquidity effects of each type of bond are significant in influencing investor's choices. ...read more.

Middle

A large proportion of the EMBI Global index debt would not have a rating of Baa/BBB or above. The five industries most heavily weighted in the Merrill Lynch index are: chemicals, utilities, energy (other), food & tobacco and gaming. Bonds will typically have at least one year remaining until maturity. For the choice dependent variables monthly averages of daily15 closing prices for each variable, from 1/1/1998 to 31/8/2004, are used, giving a sample size of 80. The reason daily data was not used is because of its volatility and noise in almost all of the time series. By averaging the data on a monthly basis the noise was greatly reduced, still allowing an adequate sample size. The timeline chosen is to incorporate the start publication of the EMBI-G index by JP Morgan, at the beginning of 1998, which takes into account recent currency crises that are of interest in monitoring the reaction of investors during liquidity changes occurring throughout these crises. Data for the whole of the Merrill Lynch High Yield Fund Index proved to be too large, as there are thousands of bonds listed in the index. Thus, in order to obtain a representative sample that was easily workable, the top 200 bonds by market capitalisation are used. This is similar to the number of bonds in the EMBI-G index so that their averages are comparable. Another problem encountered, was that during the 6 year period, bonds frequently drop in and out of the Merrill Lynch index. In order to allow for this, a snapshot of the bonds that were included in the index from the 31st January 1998 was taken and these are the bonds that monthly averages are given for up to 2004. This is to ensure that the bonds have a life span of at least the 6-year time period considered. The explanatory variables of the model include the yield on 10 year US Treasury securities, the US S&P 500 equity index and NASDAQ Composite Index, the CPI in the ...read more.

Conclusion

17 Analysis adapted from Bank of England Financial Stability Reports 1998 - 2000: http://www.bankofengland.co.uk/FSR 18 Investors that include EM debt in their portfolios if doing so appears to be advantageous 19 Analysis adapted from Global Financial Stability Review 2002 - 2004. As published by the IMF: http://www.imf.org/External/Pubs/FT/GFSR 20 The LTCM crisis was when a number of hedge funds reported substantial losses as a result of movements in global markets throughout the summer 1998. This saw a widening of credit spreads in a number of Western financial markets. 21Taken from Box 4: Bank of England Financial Stability Review, June 1999 22 Analysis adapted from Bank of England Financial Stability Reports 1998 - 2000: http://www.bankofengland.co.uk/FSR 23 Analysis adapted from Global Financial Stability Review 2002 - 2004. As published by the IMF: http://www.imf.org/External/Pubs/FT/GFSR 24 Technique as used in: HARRIS, R., SOLLIS, R. (2003) Applied Time Series Modelling and Forecasting, John Wiley & Sons Ltd. 25 See for reference: HARRIS, R., SOLLIS, R. (2003) Applied Time Series Modelling and Forecasting, John Wiley & Sons Ltd. 26 It is important to note that liquidity of the bonds increases as the bid-ask spread narrows. 27 See data appendix Table 1 for a diagnostic tests summary of the unrestricted VAR with 4 lags. 28 As calculated by PcGive 10.1 Econometric program, see for details: DOORNIK, J., HENDRY, D.F. (2001) Modelling Dynamic Systems Using PcGive, Timberlake Consultants, London 29 See data appendix Table 2 for Beta matrix values. 30 Development of Domestic Bond Markets - Compendium of Sound Practices: APEC Financial Regulators' Training Initiative: http://www.adb.org 31 View expressed by APEC: Development of Domestic Bond Markets - Compendium of Sound Practices: APEC Financial Regulators' Training Initiative: http://www.adb.org 32 According to the IMF: http://www.imf.org 33 Proposals for a Sovereign Debt Restructuring Mechanism (SDRM): IMF fact sheet (January 2003): http://www.imf.org 34 Investors that use emerging market bonds and US high-yield corporate bonds as tools to diversify their portfolios. 35 Investors that have portfolios concentrated in emerging market and US high-yield bonds in order to obtain high returns. ?? ?? ?? ?? 25 ...read more.

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