
Estimating emerging markets sovereign risk premia
Macro risk premia compensate investors for bearing broad economic uncertainty. For systematic strategies, these premia can be approximated by the difference between market-implied risk and risk implied by fundamental macroeconomic data. In the emerging market sovereign credit space, market-implied risk is represented by credit spreads and ratings, while fundamental risk factors may include government finances, external and investment balances, foreign-currency debt, political stability, medium-term economic growth, and inflation.
Macro risk premium scores, derived from this comparison, capture variations in premia paid across time and countries. Applied to 24 sovereigns over the past 25 years, these scores show significant positive predictive power for volatility-targeted returns on U.S. dollar-denominated bond indices. Compared to strategies based solely on market risk metrics, those guided by macro risk premia de-emphasize “reach for yield” behavior and deliver superior risk-adjusted returns. Moreover, the long-term performance of relative cross-currency allocations suggests that sovereign risk premia could serve as a robust foundation for adjusting bond index weights.