Predicting default probabilities and implementing trading strategies for emerging markets bond portfolios

In this paper, we address two main issues: the computation of default probability implicit in emerging markets bond prices and the impact on portfolio risks and returns of expected changes in default probability. Using a reduced-form model, weekly estimates of default probabilities for U.S. Dollar denominated Global bonds of 12 emerging markets are extrapolated for the sample period 1997–2001. The estimation of a logit type econometric model shows that weekly changes of the default probabilities can be explained by means of some capital markets factors. Recursively estimating the logit model using rolling windows of data, out-of-sample forecasts for the dynamics of default probabilities are generated and used to form portfolios of bonds. The practical application provides interesting results, both in terms of testing the ability of a naive trading strategy based on model forecasts to outperform a “customized benchmark”, and in terms of the model ability to actively manage the portfolio risk (evaluated in terms of VaR) with respect to a constant proportion allocation.