This week's graph analysis provides an insight into emerging markets yield spreads
The graph sketches out the changes occurring in emerging markets yield spreads over the past 10 years in comparison to the major stock markets in the sector.
The blue line represents the JPMorgan Emerging Markets Bond index (EMBI), which is a total-return index tracking the traded market for US dollar-denominated sovereign restructured bonds.
It includes issues such as Brady bonds, which were developed in the late 1980s as a way to finance Latin American sovereign debt and which expanded to include other emerging markets later on.
The EMBI currently includes 25 issues from eight countries, with a face value of $123.4bn and a market capitalisation of $70.4bn.
According to Franklin Templeton's emerging markets veteran Mark Mobius, the EMBI-provides investors with a well-defined performance benchmark and a vehicle for the analysis of risk and returns.
The red line represents the MSCI Emerging Market index, which is a free float-adjusted market capitalisation index that is designed to measure equity market performance of emerging markets.
The index includes 22 emerging market country indices, such as Brazil, China, Colombia, India, Poland, Russia and South Africa, and has a market capitalisation of $1.39tn.
Mobius says the chart represents a quasi-road map which helps investors to gauge confidence in emerging markets.
"It is used to see in what direction confidence is moving and thus gives an indication of what direction the stock markets may move," he says, adding it is one tool used for investments in this sector.
The right axis of the graph, which tracks the spreads of the EMBI, shows the difference between the average interest rates for emerging market sovereign bonds and US Treasury bond interest rates, shown in basis points.
The left axis, meanwhile, refers to the daily price in US dollars with gross dividends of the MSCI EM index.
Mobius says the graph tells managers there is a direct and inverse relationship between the interest rate spread and the EM index.
"If the spread is low that means confidence in emerging markets is good since investors are willing to accept a lower interest rate for emerging market bonds compared to US Treasury bonds.
"If confidence is good then the stock markets in emerging markets are high and the MSCI EM index goes up.
"If the spread is high, confidence in emerging markets is not good and investors are demanding a higher interest rate. This also suggests the stock markets in emerging markets will go down."
The graph shows the lowest spreads occurred in 2007, when confidence was higher in global markets. However, as risk aversion increased as the credit crisis began to unfold, those spreads widened once more.
"Investors were afraid of investing in anything which was perceived as being risky. They therefore retreated to US Treasury bonds and sold almost everything else including equities and equities in emerging markets," says Mobius.
He adds the spread could widen again if confidence decreases once more.
