[MUSIC] Hello, this is me again, Ines and we continue talking about emerging markets. But now, we're going to talk about bonds. After this video, you should be able to describe the relative size of emerging market bonds and distinguish between local currency denominated and dollar denominated bonds. Describe the returns and risks of emerging markets sovereign bonds and how they compare to emerging market equity. Compute a yield spread given the yields for two securities and describe the factors that determine the sovereign yield spread. If we look here at the relative contribution of the bonds, so we distinguish between the government bonds and these are issued either in local currency or in dollars and corporate bonds. And we see that the government bonds represent more about three quarters of the total market cap of emerging market bonds. What's interesting here also to see is that a larger fraction is due to local currency bond. So historically, in following that debt crisis of many Latin American countries. These countries were issuing bonds in heart currency. In currency of highly stabled government such as Dollars, the Pound, the Yen, the Swiss Franc and this is actually the bonds that are attracted for investors, but this creates a serious mismatch for the emerging market government. And now, they embarked on developing their local currency bonds and this local currency bond represents now about 53% of the total capitalization of the emerging market bonds. How about the return and risk characteristics of these sovereign bonds? Now when I say, sovereign bonds, it means bonds issued by the sovereign. Or equally, I could say, government bonds. So you see here that emerging market bonds, sovereign bonds have higher return compared, for example, to the treasury. It's not shown in this table, but these are higher returns, but also higher volatility. And what's also interesting to see here is that if we compare to equity, the emerging markets sovereign bonds have lower volatility Another interesting thing we should look at is the yield spread and it's defined as the difference between the yield on a sovereign bond, let's say, issued by an emerging market such as Brazil in dollars. For some maturity it, this bond issued by the US Treasury for the same maturity. So the two bonds have the same maturity, the same denomination. Both are in dollars, but one is issued by the Brazilian Government and the other one is issued by US Treasury. The US Treasury's safer. So, the difference between the two yields measure the yield spread. Let's take an example. The Brazilian ten-year dollar-denominated bond has a yield of 7%. The US Treasury with the same maturity ten years offer 2% yield. So here, we have a yield spread of 7 minus 2, about 5% or 500 bases points. So, let's try to understand what determines this yield spread. So what are the risks when investing in sovereign bonds and specifically, emerging Market Sovereign bonds. So, the first is interest rate risk typically measured by duration. There's also that country and credit risk. It used to be quite high especially actually for dollar denominated bonds. And now that emerging markets manages to stabilize inflation, to stabilize their government and political risk in general. They are able to issue bonds with higher credit rating, then we have currency risk. The currency risk is not an issue for dollar-denominated bonds, but is definitely an issue for local currency bonds. And unlike for equity, currency risk is quite significant for bonds. So your Swiss investor and you invest in the Brazilian sovereign bond issued in Brazilian Real. So, you care about returns with Franc. So the Swiss Franc return this Brazilian sovereign bond is the Brazilian return plus the change and exchange rate, Franc versus Brazilian Real. And a large part of the volatility in your return is going to be due to the change in exchange rate of the real versus the Swiss Franc. The other risk is liquidity risk. Sovereign parts have higher transaction costs. High [INAUDIBLE] spread and higher price impact compared to bond issued by development market governments. So what determines your spread is essentially country and credit risk and liquidity risk and liquidity risk can be quite significant, especially during crisis periods as the one we witnessed during the credit crash of 2008. So to summarize after this video, you should be able to the relative size of the bond market distinguish between local currency denominated and dollar denominated bonds and to stand the risk and return characteristics of the sovereign bonds. The measure of the yield spread given the yield for two securities and describe the factors that determine the yield spread. [MUSIC]