From Outflows to Opportunity: Emerging Market Debt Today

Introduction

Emerging market (EM) debt has suffered five consecutive years of outflows, leaving the asset class significantly under-owned. Yet the tide may be turning – 2025 represents the first year of renewed inflows, suggesting this previously neglected asset class may be staging a comeback.

We have consistently argued that US credit is broadly expensive and that investors should diversify their fixed income allocations. Having previously outlined eight reasons to consider European credit, here we examine EM debt and explain why we believe it offers an attractive opportunity for active credit managers. We will focus predominantly on EM corporate credit, while also highlighting the opportunities we see in EM FX.

#1 Valuations in EM credit continue to look cheap relative to DM credit, particularly the US

EM corporate credit offers notable value compared to developed markets, particularly the US. Since 2020, EM corporates have deleveraged in response to multiple pressures: the COVID shock, rising global interest rates, EM currency depreciation during 2021-2022, and volatile cash flows. This deleveraging has been facilitated by stronger post-pandemic earnings in certain sectors — particularly commodity exporters in Brazil, Chile, and Indonesia — which have benefited from higher inflation. These factors have led firms to prioritise resilient cash flows over cheap debt-funded growth, resulting in a what we view as a more diverse and fundamentally sound market, which we believe is yet to be fully reflected in valuation metrics.

Figure 1. EM corporates offer better fundamentals yet trade wider relative to the US

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Source: Top: BofA Securities, as of 30 September 2025. Bottom: BofA Securities, as of 30 September 2025. Leverage is calculated on last 12-month basis.

As shown in Figure 1, EM corporate credit offers superior spread compensation per unit of leverage compared to the US, demonstrating significant mispricing and attractive entry levels.

Figure 2. Attractive entry points

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Source: BofA Securities, as of 30 September 2025.

In contrast, many EM sovereigns continue to grapple with elevated debt-to-GDP ratios, structural fiscal imbalances, and vulnerability to external shocks. It is important to underscore at this point that sovereign and corporate bonds should not be conflated. Indeed, historically, we have seen stark differences in the performance of corporates versus the sovereign, highlighting the importance of selective exposure within EM debt.

#2 Dispersion available in EM corporate credit looks more attractive compared to US and European HY

We are also seeing greater dispersion in EM corporate credit compared to developed markets, with wider inter-decile spreads creating a broader opportunity set for active managers. From undervalued credit to distressed situations, this environment may offer attractive risk-adjusted returns for fundamentally-oriented investors who can distinguish between companies genuinely facing challenges and those unjustifiably affected by negative sentiment.

Figure 3. Higher spread dispersion in smaller issues of EM high yield compared to US high yield

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Source: ICE BofA Indices and Man Group, as of July 2025. Shows the median dispersion (defined as the difference in the spread of the 90th percentile and 10th percentile ) of spread levels by issue size for EM (represented as EM segment of the ICE Global HY Index (HW00)) and US High Yield (represented by ICE BofA US HY Index (H0A0). Covers period from 31 March 2019 to 31 July 2025.

#3 Regional differences create opportunities

So far, we have discussed EM as if it were a homogenous group of countries. The reality is that the term encompasses a broad and complex array of countries that are somewhat arbitrarily grouped together, despite having vastly different economic and political dynamics. This diversity means we often also see significant dispersion between countries. Take China, for example, which was previously out of favour, but which has delivered strong performance, while volatility in Argentina has created a trading opportunity. However, that is just one side of the coin and there are other markets where we currently see significant vulnerabilities, such as Indonesia and Israel. This once again highlights the critical importance of a selective, fundamentally-driven investment approach.

#4 Technical tailwinds from supply constraints

Constrained issuance in EM corporate credit has resulted in negative net supply over the past three years – a dynamic that can create upward price pressure. Supply has modestly increased year-to-date but remains supportive for the asset class. While Federal Reserve rate cuts could eventually lead to a surge in issuance, for now, current supply constraints continue to provide meaningful price support.

Figure 4. Supply has modestly increased year to date, but issuance trends remain supportive

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Source: Courtesy J.P. Morgan DataQuery, Copyright 2025. Data as of August 2025.

#5 EM FX currently looks very attractive on a historical basis

While we don't subscribe to the view that the US dollar is about to lose its status as the world’s reserve currency, we believe there may be some benefit to diversifying away from the greenback by investing in local-currency-denominated debt. Amid heightened US policy volatility, the US Dollar Index suffered its worst first-half return since the early 1970s this year as appetite for the dollar and dollar-denominated assets has waned. This backdrop, combined with improving external account fundamentals in EM, may provide opportunities in local FX, particularly given current valuations. This could also provide a tailwind to hard currency corporate borrowers with revenues in local currency and liabilities in USD.

Figure 5: EM FX currently looks very attractive on a historical basis

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Source: Bloomberg, as of 29 August 2025.

With that said, as shown in Figure 6 below, we also see significant dispersion in valuations across EM FX, demonstrating the risks involved in buying EM currencies indiscriminately.

Figure 6. Valuations vary significantly across EM FX

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Source: Bloomberg, as of 27 December 2024.

#6 Liquidity is in line with that of the high yield market

Liquidity is often cited as a key concern when investing in EM debt. While geopolitical events can create sudden market access issues – as demonstrated by Russia's exclusion from indices following sanctions – traditional liquidity concerns about the asset class are often overstated.

Most EM markets maintain reasonable trading conditions even during stress periods, with bid-ask spreads and market depth considerably better than most investors perceive.

Further, research from Morgan Stanley indicates that EM corporate secondary trading volumes have reached multi-year highs in 2025, driven primarily by high yield rather than investment grade activity. The analysis attributes this surge to major macro catalysts, including tariff announcements and the Israel-Iran conflict, alongside credit-specific situations and new issuance activity.

#7 EM is more resilient in a downturn than many investors think

Along similar lines, misconceptions abound about how this asset class performs in a downturn. Our historical analysis of peak-to-trough drawdowns and recovery periods reveals that EM debt has typically exhibited drawdown patterns and recovery timeframes comparable to US markets. The most recent cycle presents a notable exception, with EM debt having experienced an unusually prolonged recovery period. This is likely attributable to the challenging environment in China, which represents 13.5% of the index. China's property sector adjustments, evolving regulatory environment, and shifting dynamics with Western markets presented challenges that significantly influenced aggregate EM debt performance. Nevertheless, the historical data suggests that EM's recent slower recovery may represent an aberration rather than a structural shift in the asset class's risk-return profile.

Figure 7. Growth of US$100

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Source: Bloomberg. Date range: January 2000 – July 2025.

On the topic of performance, it is also important to reiterate that defaulting or coming close to defaulting on sovereign bonds will not always result in corporate defaults in the same country. We saw examples of this in 2023 when Argentinian sovereign debt narrowly avoided another default, yet many Argentinian companies, predominantly in the energy sector, demonstrated solid fundamentals and competent risk management, as well as a willingness and an ability to pay their debtors.

In addition, in recent years, local demand has become increasingly significant in emerging markets. The infeasibility of raising debt capital through hard currency bonds – driven by higher interest rates in developed markets – has forced issuers to rely more heavily on domestic lenders, who have responded in earnest. In some cases, this shift has proven valuable in limiting the severity of a market sell-off. Following the sell-off in Turkey during the first quarter of 2024, for instance, local investors stepped in to purchase dollar-denominated bonds of Turkish companies, both protecting their capital and supporting the broader domestic market.

Conclusion: An opportune moment

EM debt offers investors an attractive avenue for fixed income diversification, particularly given that US credit remains broadly overvalued. We believe the combination of attractive valuations, supportive technicals and the opportunities presented by dispersion creates a favourable environment for active credit managers. This potential new phase for EM debt makes now an interesting time for selective investors.