EM external debt is denominated in a developed market currency, typically U.S. dollars. Over the years, Euro-denominated issuance has grown. As of September 2005, 20% of the external debt bonds outstanding were denominated in euros. Despite this growth, euro-denominated bonds have lower issuance size and less liquidity than comparable U.S. dollar (USD)-denominated bonds. There is more institutional investment in USD-denominated bonds, while a larger portion of Euro-denominated bonds is held by retail accounts.

EM external debt trading occurs primarily in New York and London. Most issues settle via the ordinary Euroclear mechanism; costly local custody arrangements are unnecessary. USD-denominated, EM external debt has two important characteristics in common with U.S. corporate bonds: direct currency risk is not a major consideration and U.S. interest rate risk has an impact on EM external debt. However, while U.S. corporate bonds are subject to corporate default risk, EM external bonds are impacted by sovereign default risk.

Besides being denominated in U.S. dollars, EM external debt is governed under international law (either New York or U.K. law). There are emerging market bonds that are denominated in U.S. dollars, but governed under the local law of the issuing country. These bonds will be discussed later.

Although investor interest in EMD securities goes back to the 1800s, the acceptance of EMD into modern institutional portfolios began in the 1980s with the Brady Plan. In the 1980s, the series of bank loan defaults by many developing countries forced U.S. and some foreign commercial banks to write down the value of their loans. Narrowly defined, the Brady Plan refers to an innovative debt renegotiation format, whereby defaulted sovereign bank loans were written down and converted into bonds; the bonds themselves also have unique structures. Mexico was the first Brady Plan participant in 1989. (Former U.S. Treasury Secretary Nicholas Brady was credited with this approach.) More broadly, the Brady Plan encompasses the entire set of economic policy prescriptions that developing countries adopted in order to receive additional international aid. This aid allowed them to meet their responsibilities under the Brady Plan.

The Brady Plan differed from previous approaches in a number of respects. For the first time, underlying structural problems of the debtor countries were addressed (such as protected markets and controlled prices). Typically, the principal amount of the defaulted loans was effectively reduced by 35% to 50%; sometimes interest and interest arrears were also reduced. This principal forgiveness had the effect of both raising the loans' value in the secondary market and lowering the borrowers' debt burden. Further, the commercial banks' loans to private and sovereign entities were transformed into sovereign bonds, thus enhancing their appeal to investors.

The features of Brady bonds vary. Most were issued with a final maturity between 10 and 30 years and have semiannual coupons; many Brady bonds have amortizing principal payments. Coupons may be fixed, floating, step-up, or a hybrid combination. Unique features such as principal collateral, rolling interest guarantees, and value recovery rights were added to Brady bonds in order to improve creditworthiness and attract investors. Collateral for Brady bonds is invested in high-quality securities. Collateralized principal is invested in U.S. zero-coupon bonds; collateralized interest is invested in AA money market securities. Typically, the two next coupon payments are collateralized and the guarantee rolls when a sovereign makes the current coupon payment (hence the name "rolling interest guarantee").

Because of their interest and principal guarantees, market participants established new conventions for calculating Brady bond yields, spreads, and durations. The correct analytical procedure is to value the collateral by discounting the collateral cash flows at the appropriate spot interest rate and to subtract this collateral value from the bond's market price; the remainder is the price of the sovereign cash flows. Given the sovereign cash flows and their derived price, the bond yields and spreads can then be calculated. Statistics calculated by removing the collateral value and looking solely at the sovereign cash flows are referred to as "stripped" or "sovereign."

In addition to yield calculations, market participants have adapted traditional price sensitivity measures to the special features of Brady bonds. Interest rate duration estimates a bond's price responsiveness to changes in U.S. interest rates—all cash flows are revalued given changes in the U.S. yield curve. A bond is less sensitive to changes in U.S. interest rates if the bond's coupons are floating (that is, reset at a spread above Treasury yields). The investor is also concerned with isolating the bond's price response to a change in creditworthiness. Since only a portion of the bond's cash flows are exposed to sovereign credit risk (in some cases as little as 50%), a change in stripped spread will result in the repricing of only a subset of the cash flows (the sovereign cash flows). Thus, in addition to the standard interest rate duration measure, "spread duration" measures the bond's price responsiveness to movements in the stripped spread. If an overall widening of credit spreads is expected, the investor now has the tool to estimate which bonds will be more or less adversely affected.

Over time, the proportion of Brady bonds as a percentage of the sovereign debt universe has declined considerably. As of December 2006, Brady bonds accounted for only a small fraction of the USD-denominated sovereign bonds outstanding. The decline in importance of Brady bonds has occurred because new EM external debt issuance happens in the form of Eurobonds. Eurobonds are internationally issued securities denominated in hard currencies. Most Eurobonds have a fixed coupon and a bullet maturity.

In addition, many countries have done exchanges where they bought back Brady bonds and issued Eurobonds. Exchanging Brady bonds for Eurobonds is attractive if a country can issue Eurobonds for lower yields than existing Brady bonds (net present value savings). In some cases, countries have chosen to exchange Brady bonds for Eurobonds in order to receive cash-flow savings through lower coupons/amortizations or to release the Treasury collateral backing certain Bradys.

Eurobonds were serviced during the 1980s' bank loan crisis. A possible motivation behind such an admirable repayment history may have been that these obligations were small compared to bank debt, so that defaulting on them was much less economical. A second possible motivation may derive from the unique nature of bonds relative to loans. Debt restructuring negotiations of loans are easier because loans involve a small, easily identified, and relatively homogeneous group of creditors (that is, banks). It is difficult for a bank to not restructure its loan to a country and to free-ride on other banks' willingness to do so. By contrast, bondholders are a large and diverse group with no incentives to stay in good terms with the country. This makes broad approval of a bond restructuring more difficult.

Both Eurobonds and Brady bonds are held by a diverse group of creditors. There used to be a market perception that distressed sovereign issuers could try to selectively default on Bradys while they continue to service Eurobonds, thus maintaining some type of reputation in the market.

As it turned out, the growth of the Eurobond market eliminated the potential of preferential treatment. Since Eurobonds are now a larger portion of a sovereign's total debt, restructurings in Ecuador (2000) and Argentina (2005) included Eurobonds in order to meaningfully decrease debt burden. In the case of Ecuador, restructuring took approximately a year and only a few investors did not participate.

The Argentine default was considerably larger and the government of Argentina took a much harder negotiating stance with creditors; the government's restructuring proposal came three years after the default. A sizeable part of Argentine bondholders did not participate in the restructuring of Argentine debt in the first half of 2005. Legal battles between holdout creditors and the government of Argentina are likely to continue for many years to come. The Argentine restructuring illustrates the uncertainties of sovereign restructuring because there is no legal framework for default resolution (in contrast to the application of bankruptcy law to corporates). It also illustrates that lengthy legal battles and temporary lack of market access will not prevent an insolvent country from defaulting.

In the aftermath of the Argentine debt default, Uruguay and the Dominican Republic were able to effectively reschedule their external bonds with broad creditor consent. Creditors that did not consent had their obligations honored fully. Every sovereign default is different; it is difficult to predict how future distressed sovereigns will act.

Many developing countries have functioning and relatively liquid domestic debt markets. Local issues are issued under local law. The bulk of local issues are denominated in local currencies, but a large portion is denominated in major currencies (U.S. dollar, euro, yen) or linked to a major currency. Besides evaluating direct currency risk, international investors need to be compensated for the lack of protection offered by local laws, potential settlement difficulties and taxation issues.

The development of EM local debt markets has been encouraged by the growth of local pension fund industries and increased foreign interest. Thanks to a young population and changes in pension fund regulations, the public and private pension funds in developing countries have grown tremendously creating a stable holder of government debt.

Foreign interest in EM local debt has grown tremendously since the 1990s. After a series of devastating crises (Mexico devaluation in 1994, Asia devaluations in 1997, Russia default in 1998, Brazil devaluation in 1999, and Argentina default in 2001), many EM countries abandoned fixed exchange rates and built up their foreign exchange reserves. Many EM countries benefited from the commodity boom and greatly improved their external and fiscal ratios. This improvement led to improved credit ratings and increased investor interest and lower yields on external debt. International investors turned to local currency debt for the higher yields and because floating exchange rates and more stable economics made the massive devaluations of the past less likely.

Historically, EM local debt had very short maturity, so changes in investor sentiment quickly escalated into liquidity crises as the country had to raise interest rates rapidly to encourage rollover. In addition, a large portion of the debt was dollar-denominated or dollar-linked (similar in currency risk to external debt), so country's debt grew quickly during a currency devaluation.

Emerging markets viewed increased demand for local debt from local pension funds and foreign investors as an opportunity to improve the composition of their debt by increasing maturities and converting USD-linked debt to local currency debt. Mexico exemplifies a country at the forefront of improving its debt structure. In 2006, Mexico issued a fixed-rate 30-year peso-denominated bond. The Mexican government also issued warrants that allow holders to exchange USD-denominated debt for peso-denominated debt. Mexico's debt structure improved tremendously from 1994 when the country faced a massive liquidity crisis due in part to the rollover of short-term dollar-denominated bonds.

Since the universe of EM local debt is very large and complicated (most local bond markets have their own peculiarities), this section offers only a basic review of different types of EM local debt including USD-denominated local debt, fixed-rate bonds, floating-rate bonds, and inflation-linked bonds.

USD-denominated and USD-linked local law bonds are still a significant portion of the EM local debt universe. Historically, these instruments were issued because locals did not want to take currency risk for longer maturity bonds. However, the biggest issuer of USD-denominated local law bonds as of the end of 2006 was Argentina. Argentina issues only local law instruments because they are currently being sued in international courts following a default on external debt in 2001; any proceeds from an international law bond issue by Argentina face the risk of attachment. Since Argentine USD-denominated local law bonds are settled internationally and traded out of New York, many holders do not see a practical difference between these bonds and external debt. The difference between local law and international law bonds is limited in normal times, but comes to the forefront if there is a default.

In the 1990s, inflation declined substantially throughout EMs. But due to a long history of high inflation and substantial currency depreciations, many countries are still not able to issue long-dated fixed-rate bonds. A large part of public debt is therefore short term or floating rate.

To significantly extend the maturity structure of their domestic debt, some countries are required to issue inflation-linked bonds. In 2005, Brazil issued an inflation linked bond maturing in 2045. Inflation often increases after strong currency depreciations. Therefore, inflation-linked bonds can be expected to provide some implicit compensation for currency devaluations in the long run.

The risk analysis of an EMD corporation hinges on its ownership type and its sensitivity to domestic economy. EMD corporations may be owned by the sovereign or an established multinational or have local ownership. Sovereign-owned corporations are often referred to as quasi-sovereign. A corporation may sell its product domestically (e.g., a cable operator) or it may earn hard currency by exporting its product (e.g., an oil company).

Rating agencies have historically limited a corporation's debt rating to its country's sovereign credit rating because corporate debt manifests specific corporate business risk in addition to the sovereign risk of its government. In effect, a sovereign ceiling limited a corporation's credit ratings. The theory behind the sovereign ceiling is that the sovereign entity ultimately controls the corporation's access to foreign currency and its tax burden. Essentially, the corporation depends on a benevolent legal and institutional framework from the sovereign government and, therefore, is never a better credit risk than the sovereign itself.

Standard and Poor's (S&P) and Moody's have weakened the sovereign ceiling by allowing certain corporates to receive ratings above their sovereign ceiling. S&P sometimes rates corporations above their respective sovereign ceiling if they operate in highly dollarized economies, if they are geographically diversified or if they have offshore parent support or structural enhancements. Moody's allows corporations to be rated above the sovereign ceiling if there are external support mechanisms (that is, support from a multinational parent), if there is a low chance of a moratorium in the event of a sovereign default, and if the borrower has access to foreign exchange.

In the debt crises of the 1980s, Latin countries imposed a blanket debt moratorium on all foreign currency borrowers, many of which were corporations and banks. In recent sovereign defaults (Ecuador, Pakistan, Russia, and Ukraine), corporate access to foreign currency was not restricted by the government, but there were few corporate foreign currency borrowers. When Argentina defaulted in 2001, the government did not impose a blanket debt moratorium. However, most of the Argentine corporates defaulted on their external debt obligations.

With the exception of a few foreign-owned exporters, there remain strong arguments in support of the sovereign ceiling. Some argue that a particular international corporation, like a government-owned oil company, may be so vital to the country's access to foreign currency, that the corporation's credit reputation may supersede the country's ability to access international capital markets. However, while a nationally vital corporation may receive government assistance, it does not follow that its bondholders in general will prosper. Thus, one would expect most corporate issues to offer higher yields than their sovereign counterparts.

The credit improvement of EM sovereigns has led to less sovereign issuance (countries have smaller fiscal gaps to fill) and lower spreads for sovereign external debt. In their search for yield, investors are not only looking at USD-denominated international law EM corporate bonds, but also local currency-denominated EM corporate bonds.

Derivatives instruments that combine or eliminate different risks of EM securities represent a large and fascinating universe. Instruments can be created that combine the default risk of one country with the currency risk of another. The most basic and commonly used emerging markets debt derivatives are credit default swaps (CDSs).

The terminology used in trading CDS contracts is similar to the terminology used when someone buys an insurance contract. Each CDS contract specifies an issuer and a specific length of time (the term of the protection). One party "buys protection" against a credit event (e.g., a default); another party receives periodic payments for "selling protection." The seller of protection is long the default risk of a specific issuer for a specific length of time, similar to the holder of a bond. Conversely, the buyer of protection is short the default risk of a specific issuer, similar to someone who sells a bond short.

Sovereign CDS is quoted as a spread over the London Interbank Offered Rate (LIBOR) for a specific tenor (typically out to 10 years) creating a CDS curve for each sovereign. If an investor sells $10 million of protection for Brazil for 5 years at 200 basis points, the investor will be paid $10 million × 0.02 = $200,000 a year for 5 years. Like the holder of a Brazilian bond, the seller of Brazilian protection is long Brazilian default risk. However, the seller of Brazilian protection only has to post a small initial margin to establish a notional exposure of $10 million.

If Brazil defaults before the CDS contract expires, the buyer of Brazilian protection will receive the "insurance payment." The buyer of protection delivers $10 million notional of Brazilian securities to the seller of protection in exchange for $10 million. If Brazilian securities trade at a 70% discount post-default, $10 million notional of Brazilian securities will be worth $3 million at market prices, so the buyer of protection receives a $7 million insurance payment if Brazil defaults ($10 million payment from the protection seller in exchange for bonds valued at $3 million).

It is easy to replicate a sovereign bond by combining a sale of protection with an equal notional amount of cash. If an investor sells $10 million of Brazilian 5-year protection at 2% and holds $10 million in high-quality short-term securities earning LIBOR, the investor will create exposure that mimics a 5-year Brazilian floating-rate bond with a coupon of LIBOR+2%. An investor that creates a synthetic bond by selling CDS can calculate a price for the specific synthetic security by valuing the securities cash flows using the current CDS curve. As with a regular bond, the synthetic security's price will decline (increase) as spreads increase (decline). Fortunately, the CDSW screen on Bloomberg has become the market standard for valuing CDS.

The specific legal terminology used in CDS contracts are established by the International Swaps and Derivatives Association (ISDA). Before entering into CDS transactions, market counterparties typically sign an ISDA master agreement stating that they agree to the basic definitions. Settlement confirms outline specifics of individual trades. As with all legal documents, the devil is in the details. The ISDA master documents and the settlement confirms should clearly state what constitutes a credit event, what type of instruments are deliverable onto a CDS contract, and settlement logistics if a credit event occurs.

The J. P. Morgan Emerging Markets Bond Indices are the most commonly used by international investors. External debt investors can use one of the indices in the Emerging Markets Bond Index (EMBI) family, while investors into local markets can use the Emerging Local Markets Index (ELMI) or one of the indices in the Emerging Markets Global Bond Index (EM GBI) family. Increasingly, EMD mandates will want both external and local markets exposure with investors combining an external debt index and a local market index as a benchmark.

Bonds in the EMBI family contain either U.S. dollar-or euro-denominated sovereign bonds that were issued internationally (under either New York or U.K. law). Depending on the actual index, the EMBI indices use either ratings, country income per capita, or a debt restructuring criterion as inclusion criteria. Popular Emerging Markets Equity indices also use income per capita to classify countries for inclusion. The EMBI indices include nonrated and defaulted issuers.

Two widely used EMBI indices are the EMBI Global or the EMBI+. Once a country meets the criteria to be included in the EMBI Global or the EMBI+, a particular bond issue must meet certain liquidity requirements. The liquidity requirements used by EMD indices are stringent in comparison to those used by other bond indices. In order to be included in the EMBI Global, a bond must have at least $500 million face amount outstanding, at least 2.5 years to maturity, verifiable prices, and verifiable cash flows. In comparison, the minimum face outstanding for the Lehman Investment Grade Corporate Index and the Merrill Lynch High-Yield Index was $150 million and $100 million, respectively. The liquid nature of the JPM EM indices facilitates the trading of index swaps and allows investors to quickly implement top-down strategy changes.

EM external debt indices have poor issuer diversification when compared to U.S. High-Yield and U.S. Investment-Grade Credit indices. While most U.S. High-Yield and U.S. Investment-Grade Credit indices have hundreds of issuers, the EMBI Global and the EMBI+ have only around 40 issuers. In addition, EM external debt indices are heavily weighted toward several large countries (Brazil, Mexico, and Russia) and to the Latin region in general. Investors have an option of using a more equal-weighted version of these indices (referred to as the EMBI Global Diversified and the EMBI+ Diversified). Given the small universe of issuers, there is no way to completely remove concerns about diversification. However, since an EMD portfolio is usually a small piece of an institutional investor's portfolio, issuer diversification should be less of a concern.

Indices in the EM GBI family have only around 18 sovereign issuers. They are quite concentrated in some eastern European countries, Malaysia, Mexico, and South Africa. They include fixed-rate bonds and zero-coupon bonds. There is no other liquidity criterion than the availability of daily prices.

Many economic measures are relevant to assessing the credit risk of a developing country. One manner of organizing economic and financial considerations is to compartmentalize measures into three categories: structural, solvency, and serviceability. In addition to making the analysis more manageable by removing redundancies, this categorization produces a term structure of credit risk, akin to the well-known notion of the term structure of interest rates. An understanding of individual country politics, as well as the role of various international agencies, is also an essential part of sovereign credit analysis.

Structural

Measures belonging to this category describe the long-term fundamental health of the country. They include economic variables such as reliance on a particular commodity for export earnings, welfare indicators such as per capita gross disposable product (GNP), and social/economic measures such as income distribution. These variables generally are not directly linked to default, but countries with poor structural fundamentals are likely to develop economic problems. Further, given two countries which are similar in other respects, the one with the inferior structural measures will have a lower capacity to tolerate adverse economic shocks.

Solvency

In contrast to the structural variables, the solvency class contains intermediate-term measures of a country's economic health. In particular, these variables should reflect the country's ability, over time, to meet its central government debt obligations. Both local and external debt ratios are included in this category. Countries with inferior solvency measures, all else being equal, have higher default risk because international debt service competes with local economic constituencies for resources.

Serviceability

The factors in this category are of short-term, if not immediate, concern. They reflect the country's foreign exchange reserve position relative to its obligations (and are therefore usually presented in ratio form). Some examples include debt service (percent of exports) and short-term debt (percent of reserves). Despite good or improving fundamentals and strong solvency measures, a developing country may be forced into a crisis if its reserves are (or will become) deficient, or if alternative reserve sources, such as the International Monetary Fund (IMF), are circumscribed. Experience suggests that serviceability, or liquidity, is a paramount concern (Mahoney 1999).

Peculiar to analyzing developing country investments are certain critical political issues such as international aid and policy instability. The United States and multilateral agencies such as the World Bank and IMF have invested a great deal of political and financial capital in the recovery of developing countries and their return to the global marketplace. Therefore, an event that would ordinarily raise the likelihood of default may actually induce international organizations to assist the emerging country and reduce the probability of default. Alternatively, the movement to representative government and open markets is a recent phenomenon, and in many developing countries, there are few institutions in place to serve as anchors to these policies. The resignation or death of one key policy maker may be enough to alter economic policy. In sum, political factors can cut both ways: the politics of individual countries are often fragile, but international politics often acted as counterbalances in the past.

Despite notable attempts, multilateral agencies have been unable to influence a sovereign's relationship with its bondholders. Multilateral agencies attempted to establish a process for sovereign bankruptcy, but there was no political support to corral the interests of various bondholder groups. Despite concerns that litigious bondholders would prevent a sovereign from recovering from default, the Argentina's take-it-or-leave-it approach to bondholders in its 2005 restructuring illustrates that bondholders have limited rights against a sovereign.

While nascent representative governments may suffer from institutional instability, it is important to recognize that these countries have undergone profound political change in a short time. Most countries have moved from military rule to competitive, multiparty democracies within the decade. For example, in 1982, approximately 80% of the emerging market countries' populations were under communist or military rule; now approximately 97% are governed by democratic rule.

Some argue that sovereign risk analysis is doomed to failure because, notwithstanding the ability to pay, a country may be unwilling to make good on its debt obligations. Distinguishing sovereign risk from corporate or municipal credit risk on this basis alone exposes a deficient understanding of default risk. Borrowers default when their competing economic interests override the damage done by default. Default is never a casual decision. Corporations and municipalities are faced with the same decision as sovereign borrowers: at what point are you willing to capitulate and damage your reputation?

The major risk in emerging economies is often not the government's debt load on the economy, but access to foreign exchange. Because of previous poor policy management, weak banking systems, and ineffective leadership, many emerging countries are forced to borrow in foreign currency (usually U.S. dollars). Developing countries access foreign currency through foreign direct investment, exports, portfolio investment and official loans, all of which depend upon sound economic management and stable political leadership. This access to dollars, which is a serviceability issue, can largely be a matter of investor confidence in policy makers and is a unique risk to this market. Total external debt (public and private foreign currency denominated debt) relative to GDP for emerging countries is not significantly different from that of developed countries, but, in some cases, these developing countries have difficulty accessing foreign currency through exports or through foreign direct investment.

This additional risk aside, three macro trends may lead investors to be optimistic that emerging countries will continue their economic development process and eventually become better credit risks. First, the retreat of communism and the Soviet state signal an end to dismal economic incentives for much of the world. Second, the movement to more democratic forms of government should, in the long run, stimulate a more competitive marketplace of ideas and policies. Finally, the high rate of integration (trade, tourism, information technology, and so on) and the rapid pace of technological change make economic isolation more costly and less acceptable to the populace.

The current economic position of emerging countries is in some ways not radically different from their developed counterparts. What differentiates them is that EM borrowers have less institutional stability, less demonstrated commitment to free market principles and less reliable access to foreign exchange. These problems lead primarily to a weaker serviceability measure, but do not necessarily imply structural infirmity or insolvency.