Developed debt markets have shifted gear
Since 2022, we have been alerting investors to an apparent regime change in markets. Asset classes traditionally viewed as risk-free, such as the UK Gilt market and the US Treasury market, have seen a remarkable development: volatility in these developed debt markets has shifted gear, at times bearing a closer resemblance to what we expect from emerging markets.
Looking at the behaviour of both the emerging market (EM) and developed market (DM) asset classes from a risk and return perspective, there appears to have been a blurring of lines. Since 2022, returns have been lacklustre in DM bond markets while in EM returns have followed the historical pattern of the asset class (Figure 1); at the same time, there has been a sharp increase in DM volatility (Figure 2).
Considering first EM debt, despite the headwind of relentless US dollar strength – plus the negative impact of Russia’s local currency debt being written down to zero in 2022 – the asset class has shown resilience. This is largely thanks to orthodox monetary policy in many EM economies, with central banks wasting no time in hiking interest rates when inflation began to rise post-COVID 19. In contrast, some of the world’s largest government bond markets have suffered heavily from delayed rate-cutting cycles, given the lack of action from policymakers to tackle inflation at the onset, after deeming it ‘transitory’.
Furthermore, in DM debt markets, negative fiscal headlines have resulted in volatility spikes and nasty surprises for investors in these supposed ‘safe havens’, with the UK Gilts market a notable example. Crucially, from a forward-looking perspective, weaker fiscal dynamics in DM economies, coupled with stickier inflation, suggest this new, more volatile regime is set to persist; the blurring of lines between EM and DM is likely to endure.
Figure 1: Rolling 3-year annualised returns – DM bonds and EM local bonds
Source: JP Morgan, Bloomberg, Ninety One. January 2025. EM bond = JPM GBI-EM unhedged, DM bond = equal weighting of USD hedged US, Japan, Germany, UK, Canada, New Zealand from Bloomberg Barclays Aggregate series. For further information on indices, please see the important information section.
Figure 2: Rolling 3-year annualised volatility – DM bonds and EM local bonds
Source: JP Morgan, Bloomberg, Ninety One. January 2025. EM bond = JPM GBI-EM unhedged, DM bond = equal weighting of USD hedged US, Japan, Germany, UK, Canada, New Zealand from Bloomberg Barclays Aggregate series. For further information on indices, please see the important information section.
Fiscal dynamics: weaker in developed economies, improving in emerging markets
‘Political instability’, ‘rising populism’ and ‘unsustainable public finances’ are terms traditionally associated with EM countries, but they have become accurate descriptions for some of the world’s largest and most ‘developed’ economies in recent years. While each country’s political backstory is unique, the common theme is a pronounced deterioration of macroeconomic fundamentals. Today, glaring fiscal imbalances in the US and other ‘advanced’ economies suggest the world order has been turned on its head, with little sign of this reversing materially. Indeed, fiscal uncertainty remains prevalent in the US – potentially related to some of Trump’s tariff threats.
In stark contrast to their DM peers, fiscal fundamentals in many EM economies have strengthened over the past decade. Spurred on by the upheaval of the 2013 taper tantrum, which exposed underlying economic imbalances, many EM economies have undergone a significant rebalancing, strengthening their resilience. Even after the COVID-19 pandemic took hold, many EM policymakers remained fiscally prudent, resulting in primary fiscal balances returning to surplus within just a few years and debt-to-GDP stabilising at modest levels. The below charts illustrate the fundamental improvements of EMs vs. the US:
Figure 3: EM and US debt to GDP, %
Figure 4: EM and US primary balance (% of GDP)
Source: October 2024. IMF, Moody’s, Ninety One. EM: JPM EMBI weighted scores across 78 EM countries.
Today, there are some great examples of sound economic stewardship across the EM investment universe, with Argentina now an unlikely poster child in this regard (fiscal discipline and reform is turning around the Argentine economy). While there are notable exceptions, credible policymaking and fiscal reform is an unmistakable trend in emerging markets.
Credit ratings are starting to reflect this shift
As a reflection of deteriorating fiscal dynamics, recent action by rating agencies has seen both France and the US being given a negative outlook by one rating agency, having been downgraded by other rating agencies in the last two years. In contrast, fundamental improvements in EM economies are fuelling an improvement in rating dynamics. Combining the outlooks of S&P, Moody’s and Fitch, ratings upgrades in 2024 clearly outnumbered downgrades across EM regions. Furthermore, this positive trend looks set to continue: at the time of writing, 39 EM countries are currently on positive outlook, compared with 20 on negative outlook.
Market behaviour provides further evidence
It’s not just rating agencies that have taken note of the recent role reversal happening on the global economic stage. Across financial markets, it is evident that investors are growing cautious about the outlook for some of the world’s largest economies, factoring in a more uncertain fiscal future.
One useful bellwether of investors’ views on sovereign creditworthiness is the sovereign asset swap spread (difference between the swap yield and government bond yield)1, which indicates how much risk investors associate with the government bond compared to the swap market. When a government bond underperforms a swap, the swap spread becomes more negative – suggesting the market is pricing in higher credit risk for the sovereign. This is a phenomenon we have seen across major DM bond markets over the past few years and it has gained momentum in recent months amid growing unease over the sustainability of DM public finances, as shown in Figure 5.
The US Treasury yield curve also provides another indicator of souring of sentiment towards a developed market’s macroeconomic outlook. A bear steepening of any government bond curve — where long-term yields rise more than short-term yields in a bond sell-off — signals investor concerns about higher future debt issuance, inflation, and potential fiscal instability, leading to a greater risk premium on long-dated bonds. This unenviable phenomenon has traditionally been reserved for EM bond markets but is something we have seen more regularly in the DM space, e.g., US Treasury (Figure 6) and UK Gilt market moves in recent years.
Figure 5: 10-year asset swap spreads (swap yield – government bond yield) – UK, Eurozone and US
Figure 6: US Treasury yield – 10-year/30-year spread
Source: Bloomberg. As at January, 2025.
What this means for asset allocators
The distinction between DM and EM bond markets has become increasingly blurred in recent years, creating a challenge for asset allocators — a “quandary of the denominator.” When evaluating investments, allocators must weigh both returns (the numerator) and risk (the denominator). With DM bonds experiencing a new regime of heightened volatility, the risk side of the equation has shifted, meaning that higher returns are now required to replicate past experience. In short, with assets previously considered safe havens apparently in a new volatility regime, asset allocators face a new reality. Today, DM bonds are no longer a risk-free option, and with evidence of weaker fiscal dynamics in DM economies, this looks set to persist. In contrast, many EM economies have started to look more ‘developed’ than ‘emerging’ (and vice versa).
Naturally, in an investment universe of more than 70 countries, there will always be some exceptions; selectivity and a robust active approach are still required to ensure investors are rewarded for the risk they take. But the EM debt asset class deserves a closer – and more balanced – assessment. While DM bonds still have much to offer investors as a defensive core allocation, EM debt also warrants a place at the global investment table.
In today’s world of heightened volatility, it is not EM debt that has changed, it is DM.
1 The government bond yield represents the yield investors demand for holding a sovereign bond – incorporating the risk-free rate, liquidity premium, and issuer (government) credit risk. The swap yield reflects the market’s perception of broad interest rate conditions; credit risk is minimal as swap rates are derived from interbank markets, which are assumed to have low counterparty risk, and are collateralised daily.
General risks. The value of investments, and any income generated from them, can fall as well as rise. Past performance is not a reliable indicator of future results. Environmental, social or governance related risk events or factors, if they occur, could cause a negative impact on the value of investments.
Specific risks. Emerging market (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.
