Emerging market debt outlook: Is DM the new EM?
KEY POINTS
Diversify out of the US dollar, flee fiscal dominance
This year, the general underpinning for inflows into EM debt has been a bearish view on the US dollar (USD). While returns for EM local currency debt have been stellar, this was largely due to a weaker USD rather than strong EMFX. Interestingly, in euro terms (for European investors), performance has been modest, with the JP Morgan Government Bond Index - Emerging Markets (GBI EM) in euros, returning only +0.7%1 year-to-date. This underperformance was mainly due to the underperformance of EM currencies relative to EUR/USD, with the Chinese renminbi depreciating against the euro by approximatively 9%1 year-to-date.
EM local currency duration gains have also been modest, particularly outside Asia. In Eastern Europe, GBI EM index yields have remained stable at around 6.2%1, while in Latin America, yields have fallen by 20 basis points (bps) to 9.6%1 this year, still remaining higher than a year ago.
The primary drivers behind EM local currency returns have been the duration rally in Asia and the appreciation of the euro. We believe that these factors suggest that the asset class is benefitting from secular de-dollarization trends and increasing diversification into the large Asian fixed-income market, with China and India representing circa 20% of the GBI EM local bond index. While these themes are likely to persist, we also believe that renewed fiscal risks in developed markets could provide a fresh catalyst for increased diversification into EM local currency debt. We therefore remain positive on duration in mid-yielding EM local markets, like South Africa, Hungary or Mexico.
Trump Presidency sparks a new Gold Rush
Asia, notably China, along with Mexico and Ukraine, were seen as the main regions to be directly impacted by Trump’s policies on EM. Some expected outcomes were already priced in as early as last year, when Trump’s lead in polls increased. Ukraine’s sovereign bond delivered more than 20%1 in the three months before Trump’s inauguration, driven by hopes of an early end to the war. Argentina’s sovereign bonds also rallied, being up more than 30%1 during the same period on expectations that Trump’s presidency could help unlock a IMF programme. Conversely, the Mexican Peso, a beneficiary of the nearshoring trade, where production capacity and trade flows had been diverted from China these past few years, sold off (-9%1 over the same period) amid fears that these trade flows would reverse and due to concerns over a potential renegotiation of the United States–Mexico–Canada Agreement (USMCA).
In addition, new tariffs have not led to the depreciation in Asia FX many feared, with past dollarization acting as a buffer and countries willing to play into global trade rebalancing via stronger currencies.
Despite the ongoing war, continuous support from European countries has helped Ukraine to stay on track with its IMF program. However, choppy progress towards peace has caused Ukraine sovereign bonds to lag other CCC-rated countries that performed strongly this year, such as Pakistan (+17%)1, Sri Lanka (+14%)1 or Ecuador (+40%)1.
Furthermore, strong interlinks between the US and the Mexican economy have resulted in greater leniency from the Trump administration, with the USMCA still acting as a framework for trade relations, resulting only in modest moves in the Mexican Peso exchange rate YTD.
Trade negotiations and the search for alternative safe assets like gold have increased volatility in commodities. Year-to-date to August, precious metals such as platinum (+50%)1 and gold (+35%)1 have surged, following a 30%1 increase in 2024. Meanwhile, oil prices have fallen by 8%1 over the same period due to increasing supply and a bleaker global growth outlook. This dichotomy has led to improved terms of trade (export prices relative to import prices) for countries like South Africa, which exports platinum and gold, as well as Ghana and Uzbekistan, the 6th and 10th largest gold producers, respectively.
The rise in precious metals prices has boosted current account balances, reserves, and government revenues from taxes and royalties. Conversely, oil nations like Angola and Gabon face deteriorating outlooks, as declining oil revenues compel them to seek additional financing and implement spending cuts to balance their budgets. These trends have been reflected in spread movements: Angola and Gabon spreads have tightened by 65bps1 and 5bps1 respectively, compared to Ghana spreads which tightened by a whooping 197bps1.
Who’s EM now
It is well known that DM typically have higher debt and deficit levels than EM, while their borrowing costs are usually lower. This reflects the EM “original sin”, where countries with low fiscal credibility cannot borrow in their own currency and must rely on foreign currencies (mainly USD). This limits their debt servicing capacity to their ability to generate foreign currency inflows. Conversely, DM can finance larger deficits by accessing deeper local markets or leveraging their reserve currency status.
This balance holds as long as interest costs remain manageable. For EM sovereigns, a critical indicator is the interest-to-government revenue ratio, which signals whether debt is about to “snowball” –i.e. borrowing to repay interest on existing debt. For EM IG-rated countries, this ratio is typically close to 5%, a criterion still satisfied by France and the UK that show a ratio of 3.6% and 4.9% respectively (versus circa 3% before the pandemic). For example, France’s interest-to-revenue ratio is comparable to those of Chile, Poland, and South Korea, but France (still) has a better rating. This suggests that expecting a full one-notch downgrade of France (towards single-A territory) is realistic.
For the US, interest payments as a percentage of government revenue have historically been higher than in Europe due to lower tax rates. US government revenue-to-GDP is 31% compared to 39% in the UK and 52% in France. However, this metric is reaching questionable levels and is projected to hit 12% in 2025. Of the 18 IG-rated countries issuing debt externally, only the Philippines, Malaysia and Indonesia have higher interest-to-revenue ratios than the US, highlighting the rapid deterioration in the country’s fiscal situation, as interest-to-revenue increased by 1.6 percentage points (ppt) since pre-pandemic levels, compared to 0.6ppt for France and 1ppt for the UK.
In this context, EM offers a viable alternative to DM (especially US) bond markets, with higher real yields and more sustainable government debt metrics.
Resilience of EM corporates
Credit metrics for EM corporates remain robust, with expectations that defaults will stay below their long-term average. Low leverage levels and strong liquidity ratios serve as mitigating factors against default risk, with EM high-yield companies holding liquidity buffers in excess of their short-term obligations. Technicals remain strong in EM corporates, which are now in their fourth year of net negative supply. Moreover, EM corporate net leverage remains significantly lower than that of DM corporates. EM investment grade companies offer a spread pick-up of 60bps1 over US IG, while EM high-yield bonds provide an even more attractive pick-up of around 120bps1 compared to US HY.
- Source: AXA IM, Bloomberg, JPM indices as at 31/08/2025.
- Source: AXA IM, Bloomberg, JPM indices as at 31/08/2025.
- Source: AXA IM, Bloomberg, JPM indices as at 31/08/2025.
- Source: AXA IM, Bloomberg, JPM indices as at 31/08/2025.
- Source: AXA IM, Bloomberg, JPM indices as at 31/08/2025.
- Source: AXA IM, Bloomberg, JPM indices as at 31/08/2025.
- Source: AXA IM, Bloomberg, JPM indices as at 31/08/2025.
- Source: AXA IM, Bloomberg, JPM indices as at 31/08/2025.
- Source: AXA IM, Bloomberg, JPM indices as at 31/08/2025.
- Source: AXA IM, Bloomberg, JPM indices as at 31/08/2025.
- Source: AXA IM, Bloomberg, JPM indices as at 31/08/2025.
- Source: AXA IM, Bloomberg, JPM indices as at 31/08/2025.
- Source: AXA IM, Bloomberg, JPM indices as at 31/08/2025.
- Source: AXA IM, Bloomberg, JPM indices as at 31/08/2025.
- Source: AXA IM, Bloomberg, JPM indices as at 31/08/2025.
- Source: AXA IM, Bloomberg, JPM indices as at 31/08/2025.
- Source: AXA IM, Bloomberg, JPM indices as at 31/08/2025.
- Source: AXA IM, Bloomberg, JPM indices as at 31/08/2025.
- Source: AXA IM, Bloomberg, JPM indices as at 31/08/2025.
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