The strategy invests in CDS contracts linked to emerging market entities, ranking by credit risk factors. It forms a beta-neutral long/short portfolio, scaled to 10% volatility and rebalanced monthly.
ASSET CLASS: swaps | REGION: Emerging Markets | FREQUENCY:
Monthly | MARKET: bonds | KEYWORD: Value
I. STRATEGY IN A NUTSHELL
This long/short strategy trades 5-year CDS contracts on USD-denominated emerging market entities from the J.P. Morgan Global EMBI+ index. Each month, entities are ranked using a value measure derived from the residuals of a regression of credit spreads on credit ratings and equity volatility. The portfolio goes long on entities with lower residuals (undervalued) and short on those with higher residuals (overvalued). Beta neutrality is maintained through the asset variance-covariance matrix, and positions are scaled to a 10% volatility target with monthly rebalancing.
II. ECONOMIC RATIONALE
5-year CDS contracts offer liquid, standardized exposure to emerging market credit risk. By targeting approximately 25 stable entities across Asia, Latin America, and EMEA, the strategy captures mispricing in credit spreads relative to fundamentals while hedging beta risk. It allows investors to profit from relative value discrepancies in emerging market credit while preserving diversification and portfolio liquidity.
III. SOURCE PAPER
(Systematic) Investing in Emerging Market Debt [Click to Open PDF]
J. Brooks, AQR Capital Management LLC; S. Richardson, AQR Capital Management LLC, London Business School; Z. Xu, AQR Capital Management LLC
<Abstract>
We extend the analysis of systematic investment approaches to emerging market (EM) fixed income. We focus on hard currency bonds issued by emerging sovereign and quasi-sovereign entities. We find that systematic exposures linked to carry, defensive, momentum and valuation themes are well compensated and lowly correlated in EM markets. A transaction-cost and liquidity aware long-only portfolio generates an Information Ratio above 1. We further show that excess of benchmark returns for a broad set of EM managers are (i) largely explained by passive exposures to EM corporate credit excess returns and EM local currency returns, and (ii) have non-trivial macroeconomic exposures (growth, inflation, volatility and liquidity). A systematic approach to EM debt may be a powerful diversifier.
IV. BACKTEST PERFORMANCE
| Annualised Return | 3.7% |
| Volatility | 10.2% |
| Beta | N/A |
| Sharpe Ratio | 0.36 |
| Sortino Ratio | N/A |
| Maximum Drawdown | -31.2% |
| Win Rate | N/A |
