Dissecting the Risk of EM Sovereign Bonds

In a negative yield environment of present days the high single-digit dollar yield of emerging market sovereign bonds is indicative in itself: few believe that the principal will be repaid as debt levels are anything but sustainable. Even before the maturity, any global liquidity event could render these bonds worthless. However for a selective investor the asset class may offer a very interesting yield opportunity with limited debt sustainability and contagion risks.
There have always been plenty of wrong reasons to invest in the financial instruments issued in a collection of countries inappropriately termed emerging markets. To be clear from the onset, these countries have very little in common that would warrant bundling them together, and what is more important, as a group they are not emerging anywhere. Yet, there is at least one good reason to invest in sovereign bonds issued by some of these countries at present – reasonable yields at limited incremental risk. 
What we call reasonable yield is close to 7% for dollar-denominated sovereign paper rated BB and below. Few would argue against the reasonableness of that level given the present environment of negative yields in Europe. A somewhat more difficult argument needs to be constructed to support the assertion of limited added risk. This issue of risk wire expands on the real and perceived risks of investing in dollar-denominated EM sovereign bonds and proposes a controlled implementation process with a custom benchmark. The custom benchmark achieves a level of risk-return combination that is appealing, something that the standard benchmark fails at, particularly once we take into account all aspects of risk.
Key to our argument for limited incremental risk is that past EM crises have one way or another been induced by rising USD interest rates and unsustainable debt levels. In our earlier issues of Risk Wire this year it was demonstrated that yields were very unlikely to rise any time in the foreseeable future.
We get the first hint of the attractiveness of the asset class while comparing valuation/pricing risk across asset classes – the Graham Risk levels (Figure 1). The GR level of -2.7% for EM USD bonds means that there is at least that much yield cushion: given the current macroeconomic risk in these markets the fair compensation for risks is ~4.3% yield instead of the 7%. In other words, an investor in these bonds is overcompensated for the risks.