In 2025, moderating inflation, improving economic growth and easing monetary policy create a potentially favorable macro environment for emerging market bonds. Still, tariffs, trade barriers, the strength of the dollar and geopolitics still remain live concerns for this year.
Fundamentals also appear to be improving for the asset class.
Anders Persson, chief investment officer at Nuveen, expects default rates for emerging market high yield corporate bonds to fall to 2.7%, the lowest level since 2019 and well below long-term averages. Similarly, he predicts that sovereign high yield defaults in 2025 will be less than 1%, well below the nearly 7% average of the past five years and the 20-year average of about 2%.
And according to Bank of America Merrill Lynch, in 2024, 73% of emerging market credit rating changes were upgrades. Five years ago, in the pandemic year, 93% of EM rating changes were downgrades.
In addition, emerging market currencies are near historic low after a strong run for the dollar last year after the US election. Country debt dynamics remain healthy too, fund managers say.
In performance terms, there are signs of a turnaround. The Morningstar Emerging Markets Sovereign Bond Index is up around 1% this year in dollar terms and nearly 6% since early 2024. In 2024, the index’s strong run was halted after Trump’s election, which spurred a rally in the dollar, a key factor in EM equity and bond returns.
Are Trump Tariffs a Major Threat to Emerging Markets?
A key risk is the new Trump administration’s increase in tariffs, but there are huge differences on the potential impact depending on the country, partly due to increasing trade within emerging markets.
“China is the main target of tariffs, but the devil is often in the details,” says Fabrizio Santin, senior investment manager at Pictet AM.
Trump’s initial tariff decision “were less harsh than expected by financial traders” and were a positive surprise, he says.
“Mexico remains at the forefront because of its accumulated trade surplus with the US, but it is closely linked to the North American common economic area, and we believe Trump will especially demand greater cooperation on immigration control,” the fund manager continues.
However, Paul McNamara, investment director emerging market debt at GAM Investments, highlights the disruptive risk of tariffs, especially for Mexico and China. But these risks threaten the global economy too: “Tariffs and, more importantly, countermeasures by US trading partners risk damaging the global trading system and globalization in general.”
According to McNamara, openness to trade, and reliance on manufacturing exports, determine how vulnerable individual countries are. This is not evenly spread, however.
“Asia seems more at risk here, while Central Europe should not see its role within the EU significantly impacted”.
Beware the Dollar, Mind the Fed
Investors do not expect a serious strengthening of the US dollar in 2025 after a strong run in 2024. “We think the bulk of dollar strength is now behind us,” says McNamara. “Larger US deficits ahead seem extremely likely (and as a result strong US growth outperformance), but this will only translate to a stronger dollar if monetary policy is tight”.
Closing the economic growth differential with Europe and China, along with more fiscal discipline than expected, “could lead to a gradual weakening of the greenback,” says the Pictet manager. Growth expectations, with the US outpacing Europe and Asian, have been one reason why the dollar has been supported recently.
The main role in the EM debt market will be played by the Federal Reserve. After cuts last year, US monetary policy has entered a pause phase, with the Fed holding rates at the first policy meeting of 2025.
So far policymakers are waiting to understand the impact of Trump’s new policies on inflation and growth.
“This phase could last throughout the first part of 2025. Any new interest rate hike in the US seems unlikely at present, but it would have very negative consequences for all asset classes, including emerging market debt,” Santin continues.
Where Are the Opportunities in Emerging Market Bonds?
Nuveen’s Anders Persson says the asset class offers diversification, while EM corporate bonds offer alpha opportunities if they are combined with sovereign, or government, debt within portfolios.
Persson favors corporate bonds from stable countries such as Mexico, Brazil and South Africa.
“Brazil offers ample opportunities for global corporate competitiveness with experienced management teams. South African government stability and power generation provide an improving corporate operating environment. In Turkey, a lagging country, we look favorably on companies well positioned to withstand currency volatility. In contrast, we remain skeptical of corporate opportunities in Argentina.”
Jason DeVito, senior portfolio manager emerging market debt at Federated Hermes favors a combination of bonds from emerging and frontier, or less developed, countries. Within frontier markets, DeVito prefers bonds from sub-Saharan Africa, such as the Ivory Coast and Kenya. “Supported by improving credit profiles and attractive valuations, these countries also offer investors diversification benefits from potential macro headwinds.”
The manager also sees some interesting stories in Latin America: “In general, any boost to US economic growth may favor commodity exporters, many of which are located in Latin America.”
In terms of valuations and currencies, GAM’s McNamara says: “For a euro-based investor, EM currencies and local assets look attractive, as neither currencies nor bonds look expensive here and generally the risks are well-understood and look reasonably priced”.
Fabrizio Santin says there are opportunities in EM bonds denominated local currencies such as Brazil, Mexico and South Africa because of the inflation and interest rate profile: “The investment case for local currencies is supported by the fact that in several emerging countries real interest rates [nominal yields adjusted for inflation] are very advantageous and significantly higher than in the euro area or in the US. In the euro area.”
Overall, Santin says that EM central banks have learned from the mistakes of the past and have kept political interference at bay. EM countries have shown more fiscal discipline than their developed counterparts, especially since the pandemic, he adds.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies.
