The Impact of Rising Interest Rates on Emerging Markets Bonds

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Investors charge risk premiums and use bond yield spread of emerging market prices to off set risk associated with the rising bond market yield. Bond yield spread methodology is used to predict interest rate increase. The risk is accounted for by adjusting the expected cash flow and then discounting it by applying a weighted average cost of capital (WACC). This risk premium percentage would be compatible to assessing the value according to industry worldwide standards and that country’s overall risk. Another method investors use to cover emerging market bond risk is credit default swap (CDS). CDS transfers the credit liability between two or more parties. The purchaser of the trade makes payments to the trade's seller up until the maturity period of the bond contract (Roubini, 2015). In return the bond seller agrees that if there is a default, which means they can’t pay or experience another credit rating problem, they will pay the purchaser the security’s premium and all interest payments that would have been compensated up to the bond’s maturity date. This is the most common technique investors use to mitigate some risk and bond issuers who use this form of debt are confident in the security of their position. This is one of the few ways they could guarantee that they will pay their debt. Another technique investor’s use to off set risk is bond yield spread, which is the basis for estimating an interest rate drop or rise. The spread amongst earnings in the long and short terms has a significant association with the impending growth rate. As a consequence investors request greater returns for their long-term emerging market bonds, because the rate is expected to be higher. Investors usually use emerging government bond spread to predict future economic outlook of that country, but by using corporate bonds spread they can fine-tune their predictive capability.

There are advantages and disadvantages of the Fed raising interest rates with emerging bond markets. One disadvantage is that emerging markets are distraught with the prospect of rate increase when combined with the strong dollar (Pruit, 2004). They already have endured severe damage done by the rising dollar. In the past investors borrowed capital in dollars and invested it in high-yield developing market notes such as bonds, stocks, and property. There were also an exchange gain against the dollar on top of the higher yield. Some countries like China borrowed $1 trillion in dollars to gain from higher earnings in China. The benefits of a dwindling dollar permitted investors to make 40% to 50% of their entire profits from sales abroad. By the summer of 2014 the USD rose against other currencies and all those lucrative transactions reversed. Now emerging market bond holders are looking at a Fed rate hike with dread and disgust, because it would make the dollar even stronger, lower the bond market, and would be fatal to fragile emerging markets (Gueye, 2013). The advantage of interest rate increase is the fact that the economy is doing better and there is a higher level of spending. Higher rates mean the interest margin has expanded, which creates more profit and increases demand for bonds or other forms debt for financing.

The impact of rising interest rates on emerging markets bonds will cause all emerging markets to act on their monetary policy. The Fed has been giving warnings and limiting credit for emerging market bonds to prepare for raising the interest rate. Therefore, some markets will be better prepared, but all will have investors selling their local bonds and buying USD. Emerging markets are loathing the fed increase, because it will take capital out of their economy. Investors have come up with alternatives to offset lost and risk in the bond market. The alternatives will not stop the loss, but it will lesson it. It is inevitable for the Fed to raise interest rates and emerging bond markets to suffer loss, but when it the question. The rise of the Fed interest rate will have drastic effects on most emerging market bonds, but those who prepare like China will see minimum lost in investments.

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