Tailwinds and opportunities in EM hard currency debt

Introduction

The convergence of several key factors – including strengthening macro tailwinds, enhanced alpha-capture potential, and attractive valuations – points to a strengthening investment case for emerging market (EM) hard currency debt. This paper considers each of these, providing an up-to-date assessment of the asset class.

Tailwinds gather strength

While many EM economies began laying the groundwork for a more sustainable path several decades ago (as we have highlighted in a recent paper), COVID-19 and geopolitical events have dominated headlines in recent years, testing some of the more vulnerable parts of the investment universe. In reality – and despite all the ink spilt regarding the post-COVID EM debt crisis – defaults accounted for a small portion of the universe, and since 2022, EM economies have benefited from prudent policymaking, which has further reduced debt levels (Figure 1) and external vulnerabilities.

Today, it’s clear to see that credible monetary policy and fiscal reform is an ongoing trend in EM economies, as we noted here. Across EM economies, increasingly healthy primary fiscal balances are in evidence (Figure 2). Funding strength is better than in the pre-2012 (taper-tantrum) period, thanks to growth in local funding markets, and external resilience has improved post-COVID on stronger basic balances (current account + FDI). While the uncertain global macro and geopolitical backdrop will dampen headline growth in EM economies, the structural economic growth premium of EM relative to developed markets (DMs) remains intact and above its long-term average, as shown in the Appendix.

Figure 1: EM and US debt to GDP, %

Source: October 2024, IMF, Moody’s, Ninety One. EM: JPM EMBI weighted scores across 78 EM countries.

Figure 2: EM and US primary balance (% of GDP)

Source: October 2024, IMF, Moody’s, Ninety One. EM: JPM EMBI weighted scores across 78 EM countries. While the US is not a like-for-like peer group for EM sovereigns, it serves as a relevant anchor for comparison given its role as the issuer of the global reserve currency and the benchmark for USD-denominated debt markets. The comparison is used here to highlight the relative fiscal discipline of EMs in a context where investors may overlook it.

This trend of fundamental improvements has not gone unnoticed by credit rating agencies. Combining the outlooks of S&P, Moody’s and Fitch, ratings upgrades in 2024 clearly outnumbered downgrades across EM regions. Figure 3 shows the net rating action moved into positive territory for the first time since the COVID-19 pandemic. This positive trend looks set to continue; at the time of writing, 44 EM countries are currently on positive outlook, compared with 29 on negative outlook, creating one of the strongest rating outlooks in EM rating cycles that we have seen for some time.

Figure 3. EM upgrades vs downgrades (12-month rolling)

Source: Ninety One calculations, as of January 2025. Upgrades vs downgrades takes into account sovereign long-term HC ratings from Fitch, S&P and Moody’s.

Crucially for investors, these improving dynamics present a tailwind for the asset class, while also creating opportunities to benefit from a tightening of credit spreads relating to rising stars (countries moving from high yield to investment grade). These dynamics may warrant a strategic reappraisal of EM hard currency debt allocations.

Opportunities to capture alpha are expanding

An important consideration for active investors is that as the EM hard currency market has evolved and matured, it has become significantly more diverse.

From being dominated by Latin American markets at its inception, the flagship index (JPMorgan EMBI Global Diversified, or ‘EMBI’) has broadened to include an increasing number of ‘frontier’ markets and a number of investment-grade Middle Eastern markets.

Frontier markets now account for around a quarter of the EMBI. The increased importance of frontier markets in the EMBI offers the opportunity for investors to take meaningful – and diversified – exposure to a broad range of underlying return drivers. These smaller and often less liquid markets are typically under-researched by the mainstream investment community and rife with information asymmetries, bringing greater potential for alpha capture to those willing and able to do the necessary analysis.

The broadening of the asset class has resulted in a high level of return dispersion within it – as evidenced in the Appendix. This is a pattern that we expect to continue, with market volatility likely to remain more elevated than in the recent past due to ongoing political and geopolitical risks, which will result in winners and losers. This increased level of dispersion can be further demonstrated by an analysis of the best and worst performing markets in the JP Morgan EMBI over the past five years (to end February 2025); these range from Argentina’s +13% annualised return to Ukraine’s -11%.

This high level of dispersion provides significant alpha opportunities, particularly through country and security selection. For active managers with the right expertise, this diverse market is a rich hunting ground, and the stark contrast between top and bottom performers underscores the value of a selective, bottom-up approach.

Of course, there are always exceptions in this highly diverse investment universe and the decision where not to invest is equally as important as the decision where to allocate capital, as the examples below illustrate.

Markets that we believe are showing promise

• Paraguay: Strong fiscal, reform and debt dynamics should support Paraguay in achieving an investment-grade rating from all rating agencies over the next 12–18 months.
• Argentina: The country continues to exhibit a positive structural story and its bond market benefits from high carry. Optimism around a renewed IMF programme and the future relaxation of capital controls, amid a strong fiscal backdrop and rebounding economic activity, paints a positive picture.
• Egypt: An IMF programme and sizeable injection of funding from other bi-and multilateral partners following the market turmoil seen several years ago have provided Egypt’s policymakers with significant room to enact reforms. In addition to reducing fiscal and debt vulnerabilities, the country is enhancing fiscal transparency, and an ambitious privatisation programme is underway.

Markets warranting caution

• Brazil: Fiscal dynamics are deteriorating, with rising public debt and weak political commitment to fiscal consolidation. The government’s backtracking on spending caps, pressure to increase social expenditures, and sluggish structural reforms compounds concerns.
• Angola: A lack of a clear reform path is cause for concern. Fiscal consolidation remains challenging, partly due to the difficulties in reducing the fuel subsidies, while a reliance on oil revenues remains a risk.
• Bahrain: Credit metrics are particularly weak in Bahrain, with limited economic-reform impetus. In addition, given an assumed financial backstop from the Gulf Cooperation Council, Bahrain’s bonds trade tight for their credit rating.

Valuations present an attractive entry point

Despite continued improvements in credit quality, spreads in the EM hard currency sovereign debt market have widened in recent months – a move driven more by broader market volatility rather than by EM-specific fundamentals. As a result, valuations remain attractive relative to other comparable asset classes, particularly given the underlying structural strength and resilience of many EM sovereigns.

Considering the asset class in a historical context, spreads in the EM hard currency debt market are still wide relative to their 10-year history (71st percentile). Compare that to the US high-yield market, where spreads are in their 50th percentile (Figure 4); the potential for credit spread tightening appears materially higher in the EM hard currency debt market.

Figure 4: Current spreads and percentile rank over the last decade

Source: Bloomberg, JPMorgan, Ninety One Calculations, 30 April 2025. Spreads used are Z-spreads.

Beyond headline spreads, the case remains compelling when viewed through a credit-risk-adjusted lens. On a loss-adjusted basis (spread per unit of historic default), EM sovereign debt continues to offer investors a healthy level of compensation. Using 10-year average default rates (2014–2024), EM provides ~30% more spread per unit of default risk than US high yield.

That said, we believe the 2014–2019 period is a more meaningful baseline than the past decade. The years since 2020 have been heavily shaped by non-recurring shocks – notably COVID-19, the Russia/Ukraine war, and an unusually strong US policy response (including large fiscal deficits and monetary stimulus) that buoyed fundamentals in the US high-yield market. Excluding these outliers, EM’s relative resilience and favourable risk/reward profile is even clearer: over 2014–2019, EM sovereign debt delivered 2x the risk-adjusted spread of the US high-yield market, driven by improving credit quality and more disciplined policymaking.

Figure 5: EM sovereign debt offers a favourable risk-reward profile

Source: Ninety One, Bloomberg, JP Morgan as at 30 April 2025. Spreads shown for JPM EMBI Global Diversified Composite (z-spread) and Bloomberg US Corporate High Yield Total Return Index Value Unhedged USD (OAS). Risk-adjusted spread is calculated as spread/default rate.

In addition to better credit-adjusted spreads, investors in EM hard currency debt benefit from meaningful carry support¹. With a yield of 7.55% and a duration of 6.6 years, investors benefit from a ‘carry cushion’ of approximately 114 basis points, meaning spreads could widen by more than 1% over the next year and the asset class would still be expected to deliver a flat or positive return. This yield buffer, combined with lower structural default rates, provides a resilient foundation for long-term total returns, in our view.

Getting the most out of the asset class

While the potential rewards are significant when investing in the EM hard currency debt universe, the risks of encountering sizeable drawdowns are also high. Here are some rules of thumb for maximising alpha-capture potential while seeking to minimise the risk of costly negative surprises:

1. Risk-aware portfolio construction is key to ensure diversified sources of returns in a hard currency EM debt portfolio. A risk-unit approach allows managers to reduce concentration risk in this regard and can help avoid getting caught in a single theme.
2. Harness the full opportunity set: the resources and ability to research even the smallest frontier markets create an edge and ensure all potential alpha opportunities are pursued.
3. Active and unconstrained: in a universe where the return dispersion is so high, it’s important to be able to take a zero weight in markets that look vulnerable or where credit events loom large. This highly inefficient investment universe warrants a high-conviction, benchmark-agnostic approach.

In summary

A confluence of factors – including favourable fundamentals, rating upgrades, compelling valuations and positive supply/demand dynamics – are supporting the investment case for an allocation to EM hard currency debt. This is a good entry point for investors considering the asset class, in our view.

Appendix

Dispersion between the top and bottom country year-on-year returns

Source: Bloomberg, Ninety One Calculations. July 2024. Solid dark line is the top performing EMBI country minus the worst. The dashed line is a 1 year moving average. For further information on indices, please see the Important information section.

Emerging markets have maintained a real GDP growth premium over developed markets averaging 2% since 1980. While the differential has narrowed from its 2000s peak, IMF forecasts suggest the premium will persist, supporting the structural case for an EM allocation.

EM/DM growth differential

Source: IMF, as at April 2025.

¹ Carry support = Yield to maturity/duration. Data shown for JPM EMBI Global Diversified Composite as at 30 April 2025.