The trend towards globalization and the decline in international investment barriers experienced over the last two decades have resulted in increased international capital movements. Bonds in emerging markets have been initially viewed by investors as high-yield substitutes for equities. Although emerging market bonds are conspicuous for their high average returns, their returns are associated with idosyncratic country factors and give rise to different sources of risk as compared with developed market bonds (Erb et al., 1999).
This paper studies the predictable component in the changes in the emerging market bond index (EMBI), a total return index for the country's most liquid Brady bonds. For a more comprehensive and clearer investigation of the determinants of emerging market bond returns, we consider the country-specific risk, the development of local financial markets and the structural break of capital flows in predicting emerging market bond returns.
Predictability in emerging markets bond returns has not yet been thoroughly investigated. Most research focuses on predictability in equity and bond returns in developed markets (see Bekaert and Hodrick, 1992; Ferson and Harvey, 1993; Ilmanen, 1995; Avramov, 2002; Ang and Bekaert, 2007; and Avramov and Chordia, 2006, among others), as well as in emerging market equity returns (see Harvey, 1995; Bekaert and Harvey, 1995, 2003, among others). Recent studies of emerging bond markets have focused on the pricing and issuance of Brady debt (see Duffie, Pedersen, and Singleton, 2003, among others). By contrast, only a few papers work on identifying fundamental determinants of bond returns (Jüttner et al., 2006; Lin et al. 2007) and spreads (Min et al., 2003; Jostava, 2006).
Although the global factors are found to be important in determining developed market bond returns, local factors are having a more important influence on the emerging market bond returns and yields, as concluded in Min et al. (2003), Jostova (2006), Jüttner et al. (2006) , and Lin et al. (2007). Other than using the most studied local factors macroeconomic fundamentals, we also consider country risk, foreign capital flows, and financial market developments in predicting emerging market bond returns, as suggested in Bekaert and Harvey's (2003) examination of emerging equity returns.
