Emerging Market Debt: A Potential Turning Point?

Edwin Gutierrez Head of Emerging Market Sovereign Debt
 

Amid signs of revival and shifting global dynamics, a look at the compelling opportunities across high yield, local currency, and corporate emerging market bonds.

A turning point in a story is a moment in the plot when a character must make a decision that will change the course of the story. 

Every turn involves a decisive change, either advancing character development or propelling the story forward (e.g., King Lear's realization of the true nature of his three daughters or Luke's discovery of his father's identity). The choices the characters make will change the direction of the plot and, in turn, their future.

After a decade marked by volatility, capital outflows, and a strong dollar, emerging market (EM) debt may be nearing such a turning point. 

For fixed income investors seeking yield and diversification, the current macroeconomic and geopolitical landscape presents both challenges and opportunities. 

With spreads in high yield and frontier markets appearing attractive, structural reforms gaining traction, and multilateral support remaining robust, the case for selective re-engagement in EM debt is strengthening.

Value amid volatility

One of the most compelling areas within EM debt today is the high yields in the frontier space. 

Spreads remain wide relative to historical averages, offering a cushion against potential global shocks. These markets are often underpinned by improving fundamentals, including fiscal consolidation, governance reforms, and enhanced engagement with multilateral institutions such as the International Monetary Fund and World Bank. For example, countries such as Egypt, Kenya, and Pakistan have made significant strides in securing external financing and implementing structural reforms, which in turn bolster investor confidence.

Moreover, the technical backdrop is supportive. Many frontier issuers have limited access to capital markets, leading to constrained net supply. This scarcity, combined with high nominal and real yields, creates a favorable risk-reward dynamic for investors willing to navigate idiosyncratic risks.

A tactical shift

While high yield remains attractive, the outlook for investment grade (IG) EM debt is evolving. 

With the growing risk of a US recession, which could trigger a rally in US Treasuries, the relative appeal of IG EM debt has improved. As such, many investors are tactically reducing their underweight positions in IG sovereigns and corporates. Countries like Mexico, Indonesia, and Chile offer relatively stable macroeconomic frameworks and benefit from strong institutional support, making them appealing in a risk-off environment.

This shift is not merely defensive. We believe IG EM debt can serve as a ballast in portfolios, especially if global growth slows and risk appetite wanes. The potential for capital appreciation in a Treasury rally scenario only adds another layer of appeal.

A reawakening?

Perhaps the most intriguing development is the potential resurgence of EM local currency debt. 

After years of underperformance driven by a strong dollar and inflationary pressures, the tide may be turning. The weakening of the dollar, questions over the US exceptionalism trade, and the end of aggressive rate hikes by the Federal Reserve are creating a more favorable backdrop for local currency bonds.

Many EM central banks were ahead of the curve in tightening monetary policy and are now able to ease monetary policy proactively. Countries such as Brazil, Chile, and Hungary have already begun cutting rates, and others are expected to follow as inflation moderates due to favorable base effects. This creates a supportive environment for local bonds, particularly in Latin America, where real rates remain among the most attractive globally.

Currency dynamics are also shifting. With the dollar losing momentum and EM currencies undervalued on a real effective exchange rate basis, there is room for appreciation. This could enhance total returns for dollar-based investors and further support flows into local markets.

Fundamentals remain resilient

In the corporate space, fundamentals remain broadly supportive. 

Despite the global slowdown, EM corporates have maintained healthy balance sheets, characterized by low leverage and strong interest coverage ratios. Many companies have taken advantage of past periods of market access to term out debt and reduce refinancing risk.

Notably, net supply in the EM corporate bond market is expected to remain negative. Companies are prioritizing debt repayment over new issuance, which supports technicals and helps mitigate spread widening in periods of volatility. While operational performance may face headwinds from slower global growth, we believe the overall credit quality of the asset class remains robust.

Headwinds on the horizon?

Despite the improving backdrop, several risks could derail the EM debt recovery. 

Chief among them is the potential for a full-fledged trade war, particularly between the US and China. Such a scenario could severely impact EM exports and lead to protectionist policies that disadvantage developing economies.

A US recession, while potentially supportive for Treasuries, could also dampen global risk appetite and lead to capital outflows from EM assets. Similarly, a failure of the Chinese economy would be a sharp deceleration in the economy, as we are not expecting much of a rebound in growth. Though, to rebound meaningfully would weigh on commodity prices, particularly oil – a key export for many EM countries.

Geopolitical tensions remain elevated. The ongoing war in Ukraine shows no signs of resolution, the Israel-Iran conflict rages on, and adversarial posturing by countries like Russia and China could test the resolve of the Trump administration, potentially leading to greater instability in the Middle East and Asia-Pacific regions.

Final thoughts

While uncertainties persist, we believe the current environment presents a potential turning point for EM debt. The combination of attractive valuations, improving fundamentals, and shifting global macro dynamics creates a compelling case for re-engagement. For investors willing to take a long-term view and navigate short-term volatility, we believe EM fixed income offers a unique opportunity to enhance yield and diversify portfolios in a world of slowing growth and evolving risks.

FOR PROFESSIONAL INVESTORS ONLY. NOT FOR USE BY RETAIL INVESTORS.

Important information

Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.

Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).

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