In the shadow of country risk: asset pricing model of emerging market corporate bonds

We examine the covariances of corporate bonds in emerging markets (EM) and present an asset pricing framework using instrumented principal component analysis (IPCA) that includes characteristics at the sovereign and bond levels. Our results indicate that EM bond returns are significantly influenced by country-specific risks. Incorporating these characteristics can improve both the total and cross-sectional model fit. We demonstrate that a factor framework tailored to the nuances of the EM universe generates a significant alpha of 2% per annum against the market and a higher information ratio than alternative asset pricing models, such as a conditional beta model designed for developed market (DM) bonds.