EM Bonds: Restructured and Ready for Select Returns in 2025?

EM Bonds: Restructured and Ready for Select Returns in 2025?

The overall tone towards lower-rated Emerging Market debt has been helped by the tailwind of a broader risk-on sentiment.

One of the key opportunity sets (and risks) for investors in Emerging Market bonds over the past few years has been sovereign restructurings undertaken by developing countries swimming in debt. Prior to the pandemic, many Emerging Market (EM) sovereigns took advantage of low rates by loading up on cheap debt, only to face the harsh reality of ballooning servicing costs and, for some, the inability to pay when rates shot up after the pandemic. Typically, the restructuring process was long and drawn out, with many players both domestically and internationally vying to carve out the best possible outcome for themselves.

It's said that necessity is the mother of invention, and if there was one positive that came from the tumult of the recent post-pandemic years, it might be that a more robust approach to debt restructurings has emerged, sometimes incorporating tailored value recovery instruments, that could enable investors to recoup some or all of what they may have lost in the past. The perhaps better news is that, as 2024 comes to a close, many Emerging Market sovereign restructurings have come to an end as well, at least for this round.

In fact, many countries that were previously the worst U.S. Dollar-denominated EM sovereign bond performers are just coming out the other side and are near the top of the tables this year. The likes of Sri Lanka, Zambia and Ghana, for example, have helped high yield-rated countries beat their safer investment grade counterparts by more than fivefold. Even more stellar performers include countries that restructured their debt a few years ago, but are still trying to cement their recovery – for instance, Argentina and Ecuador. 

Are all these countries out of the woods from a debt perspective? Clearly, no. Yet the overall tone towards lower-rated emerging market debt has been helped by the tailwind of a broader risk-on sentiment.  The U.S. Federal Reserve (Fed) finally starting to lower policy rates in September was instrumental in supporting this narrative, largely built on the hopes of more easing to come.

Things didn’t start out that way.  As 2024 began, a more resilient than expected U.S. economy threw cold water on the size and scope of potential Fed easing. It did (finally) begin to ease, but today we are faced with a similar situation, where the U.S. economy is still the standout global growth driver. Now, global financial markets are once again grappling with how much further the Fed can ease or even if a pause might be in the cards.

Fed policy, as it always seems to be, will be a huge factor for EM bonds as we move into 2025. As important as the Fed is, however, we believe it may not be the biggest influencer of emerging market sentiment next year. Global financial markets are now digesting Donald Trump’s presidential election victory and what a second Trump presidency could bring. Sentiment towards Emerging Market debt was already somewhat shaky in the run-up to the election, and the level of nervousness has only risen since then.

Much of the worry is on the trade front: who Trump will target, and what form of protectionism they will face. China is in the crosshairs again, having been a target during his first term. This time around, the focus could also turn to countries that are acting as go-betweens for Chinese goods entering the U.S. A prime example is Mexico, which has already been under pressure since a landslide election in the spring handed the incumbent party sweeping powers to implement desired reforms.  

Countries tackling their own, more pronounced idiosyncratic risks may be somewhat removed from what is going on globally right now from both an economic and political perspective. Turkey, for one, has been a bright spot for investors as it is finally trying to tackle inflation in a more orthodox way. We believe focusing on countries that are just emerging from restructuring or that are experiencing an upswing in their domestic economy could also be good candidates as potential buffer zones from global trends.  

Today’s investing environment really stresses the need for a targeted focus on individual stories. However, even today’s preferred trades could suffer tomorrow if the general risk tone on Emerging Market debt turns sour. If inflation fears return and make the Fed do an about-face on rates, all bets are off, and Trump’s trade policies may have a big effect.

The recent batch of firmer U.S. economic data have markets nervous as they contemplate a slower pace to Fed easing. Should this occur, it would most likely dampen optimism around future cuts by emerging market central banks. 

Emerging Markets overall tend to be very influenced by the health of the global economy and we expect there would likely be big headwinds to this growth picture should a higher for longer rate narrative get reinforced again.