Emerging Market Sovereign Credit Spreads: In-Sample and Out-of-Sample Predictability

Using weekly data we examine the quarter-ahead predictability of emerging market credit spreads for four large sovereign markets before and after the Lehman Brothers' default. A baseline model exploiting information from the credit spread curve alone predicts no better than the canonical random walk and slope regression benchmarks. Extensions with global yield curve factors and volatility of the global short-term interest rate produce better forecasts that outperform both benchmarks, albeit only post-Lehman. Adding domestic macroeconomic volatility indicators further improves the forecasts especially post-Lehman. The analysis reveals that credit spreads become more closely aligned with fundamentals post-crisis.