Emerging market spreads under the radar

Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below.

All data referenced in this article are sourced from Bloomberg unless otherwise stated, and is accurate at the time of publishing.

Key points

• Emerging market bonds have outperformed US Treasuries and US corporate bonds since late 2022 – driven partly by positive economic news in emerging markets themselves 
• Strong growth in India and other emerging markets could further support bond performance
• Unlike past cycles, emerging market bonds might continue to see good returns and investment flows even if leading central banks cut rates
• There appears to be room for emerging market bond yields to tighten further. While India and Mexico stand out for potential returns relative to risk, Turkey might see even more compression

Emerging market bonds in average have enjoyed stellar performance since October 2022. The Bloomberg emerging market aggregate USD index, outperformed not only US Treasuries but also US corporate investment grade bonds, as well as USD high yield bonds, thanks to performance of over 20% since October 2022. 

Growth outlook differs

The backdrop for emerging market bonds has been very supportive in recent months with a US rate cutting cycle in the offing. A very resilient US economy and a robust macroeconomic backdrop in emerging markets have helped too. A slowdown in growth from 3.2% in 2023, to 2.9% for both 2024 and 2025, seems likely for the global economy. But it still appears to be a far more constructive outlook as previously feared. 

At the same time, inflation is likely to continue to moderate further as most local central banks have followed global policymakers shifting to a tighter monetary stance. That said, emerging markets comprise of a broad range of distinct economic circumstances. 

While Argentinean gross domestic product (GDP) is expected to decline by 4% this year, India is likely to grow by a remarkable 7% in 2024 and 2025. By contrast, emerging Europe, the Middle East and African countries should see growth of around 2.6% in average. Meanwhile, in the Americas, Mexico (3%) should not only trump Argentina but also Brazil (1.9%) in each of the next two years.

What next for emerging market bonds?

After a strong run last year, can emerging market (EM) bonds continue to outperform?  The typical perception seems to be that a transition from higher to lower US rates attracts ‘carry-trade’ flows into EM assets, providing a further boost to performance. 

That said, history shows that EM bonds have only ever once outperformed US dollar-denominated corporate investment grade bonds, for example, once the Fed started to cut its policy rate. The exception being in 1994 (see chart). 

EM bonds and Fed monetary policy

The performance of EM bonds and US dollar-denominated global aggregate bond index compared with the fed funds rate since 1994

The reason is that the Fed usually loosens its monetary stance when cracks in its own, or the global, economy emerge. This, in turn, tends to trigger a flight to safety as fund flows depart emerging market assets, hitting performance. 

EM bonds’ large outperformance may seem unlikely and it is important to consider that the primary reason for potential rates cuts is a retreat of inflation rather than economic worries. As such, there is a smaller risk of large outflows out of emerging market bonds.

Spreads the driving factor

With the prospect of lower trending policy rates, which was reinforced by the updated Fed’s projection in March that the policy rate would be cut three times in 2024, global bond markets already shifted into hunt-for-yield mode. This, in turn, led to an acceleration of spread compression across global credit markets, as pointed out in The right temperature for corporate credit?. 

In aggregate, spreads of emerging market yield against US Treasuries have tightened to 260 basis points (bp), the tightest levels seen since 2021. This seems some way off the typical spread highs of between 430bp to 460bp seen during the last 15 years (with the exception of the COVID-19 pandemic and global financial crisis).

Spread levels, as opposed to spread trends, before cutting cycles also play a major factor for performance prospects. Historically, the halt in outperformance was not only triggered by higher trending spreads at the time when global central banks reacted to deteriorating economic dynamics with policy rate cuts. 

Spreads have usually already been very tight going into a repricing phase to begin with – ultimately the nature of price dynamics during cycles. By contrast, EM bonds have tended to perform well after spread peaks.

Two years of spread tightening?

But low spread levels do not necessary imply immediate repricing risk. In the absence of a large crisis or contraction in output, a further tightening in spreads seems a reasonable prospect. Such periods could be seen between 2016 and 2018 (spread tights: 210bp) or between 2011 to 2013 (spread tights: 250bp). 

The air for further spread tightening, and thus outperformance, might be getting thin, but global bond investors seem to be willing to ignore tight spreads, given the relatively high yields which can be achieved. As a result, relatively stable or tighter spreads could be possible this year.

Which countries stand out?

At the country level, prospects seem to mirror the broader EM bond price dynamics (see chart). In each of the countries or areas shown, bond spreads trade well below its respective mean level over the last 15 years. 

It is therefore not surprising that spread levels in isolation on a country level are not necessarily pointing to the next winners. In the context of each country’s growth prospects, and in the absence of any major crisis, there appears to be further room for spreads to narrow, potentially towards their respective lows. 

India and Mexico (as discussed above) stand out from a risk-return perspective, while Turkish spreads appear to offer room for further compression. 

Emerging market spreads are below long-term averages 

Spread levels for debt in various emerging markets are down on the average level seen in the last fifteen years

Conclusion

EM bond valuations do not look  overly attractive in absolute or in relative terms compared with historical levels or other debt markets. A relatively robust growth backdrop, as seen in India for example, however, leaves potential scope for select opportunities.

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