Emerging market debt: Five takeaways for 2025

Idiosyncratic narratives have been a key driver of market sentiment in 2024, underpinning the outperformance of several distressed issuers, while upward rating momentum has supported sovereign credits at the cusp of investment-grade (IG) status. While these positive forces should be sustained and offer discrete spread opportunities, an evolving emerging market (EM) universe should also lead investors to focus on instrument selection as a driver of alpha in 2025. Capital market access for distressed borrowers could attract more attention later in the year, while the threat of sovereign debt regulation may cause a headline distraction. Moreover, EM investors will have to navigate a material shift in the US political landscape, with the confirmation of Donald Trump as US president and a Republican-controlled Congress in both houses. US policy is likely to have meaningful implications for EM economies, creating both winners and losers, and leading us to maintain a cautious view on EM foreign exchange (FX).
 

1. Idiosyncratic and “rising star” narratives sustain a positive fundamental outlook
   We expect positive momentum within EM high yield (HY) to be sustained, where we see the most value, focused on the conclusion of debt restructuring talks (Sri Lanka and Ethiopia) and country-specific reform programs (Argentina, Türkiye, South Africa, Egypt and Serbia). Upward credit ratings momentum should continue following a stream of upgrades in the second half of 2024, with several countries potentially achieving IG status. Paraguay and Serbia are on the path to receiving full IG status after receiving their first individual IG ratings during the third quarter, while Brazil is at the cusp of an IG upgrade. Conversely, while some investors have considered a potential downgrade for Mexico plausible, we do not concur given the constructive fundamentals in the longer term, focused on nearshoring and ongoing US investment. As ever, though, the shift toward economic orthodoxy will be uneven across the EM universe. A path toward democratic rule remains elusive in Venezuela, while doubts remain over similar transitions in certain sub-Saharan African countries. Other trends include countries under authoritarian auspices, such as in Eastern Europe, which are contending with challenges to the liberal order. Meanwhile, several sovereigns are having to balance the containment of social tensions with the need for fiscal consolidation, such as in Kenya or some parts of Latin America. Furthermore, the ongoing conflicts in the Ukraine and the Middle East will test the international community’s diplomatic and financial resolve.
    
2. Sovereign default risk avoided, but focus shifts to longer-term market access
   We do not foresee any new sovereign defaults occurring over the next 12 months. Near-term repayment and liquidity risks have been eased by generous external funding announcements, supporting countries’ structural reform programs, while geopolitical considerations have provided another impulse to support vulnerable countries in unstable regions. More innovative ways of reprofiling debt obligations are also being found, such as debt-for-nature swaps, as seen with El Salvador, which are helping to reduce external financing costs and manage liabilities. However, moving through the year, investors may start to focus on 2026/2027 obligations, bringing into focus capital market access for EM HY borrowers once again. Although more conducive financial conditions should reduce the barriers to entry for HY borrowers, the onus to secure private financing will be on countries’ demonstrable progress in advancing the structural reform agenda, including fiscal consolidation and debt reduction. Legislative elections in key economies, such as Egypt, Ecuador and Argentina, where the next reform phase will involve lifting capital controls and moving to a flexible exchange rate, will be scrutinized in 2025 as a gauge of the authorities’ political capital to continue to implement change.
    
3. More instrument variability creates pricing inefficiencies
   As EM sovereign spreads have seen broad-based compression, we believe security selection is likely to feature more heavily in delivering alpha opportunities. Across the universe, we are seeing more instrument variability resulting from recent debt restructuring outcomes, leading to a more complex and differentiated market environment but one that creates opportunities for active investors. State-contingent debt instruments (SCDIs) have featured heavily in recent debt restructuring agreements, namely Zambia, Suriname, Ukraine and Sri Lanka, and have closed the gap between debtors and creditors by potentially boosting recovery values while adjusting debt relief with the ability to pay linked to key economic variables. Step-up features in the form of coupon and/principal payments have been sized against defined economic outcomes. SCDIs offer two advantages to investors. First, provisions have been tightened to avoid debtors managing a favorable outcome to the detriment of creditors (as occurred with Argentina in 2013). Second, they have been structured as a bond, rather than an equity-like, gross-domestic-product -linked warrant, leading to their inclusion in the major EM indexes, which should help to improve liquidity and attract a wider investor base. Over time, investors are likely to assess the effectiveness of these instruments and the impact upon price.
    
4. Debt relief activism in 2025, a “Jubilee” year, might reignite efforts for legislative changes
   Attempts to reform New York (NY) state law governing EM sovereign debt (covering 50% of EM sovereigns) through the proposed Sovereign Debt Stability Act (SDSA) were unsuccessful in the first half of 2024. Strong concerns were raised among investors around the explicit cap on recoveries for bondholders regardless of the situation, as well as the many legal anomalies due to a lack of consultation and the potential unintended consequences of increased borrowing costs for debtors. The Champerty Bill was offered as a compromise but fell short of receiving full legislative approval. However, Sri Lanka’s agreement-in-principle (AIP) provided a signal that concerns around changes to NY law have not faded. The AIP included a provision to allow creditors to change from NY to English or Delaware law subject to certain thresholds being met. Further efforts to reintroduce the SDSA proposals might be sought in 2025, which has been termed a “Jubilee” year to harness attention on the issue of debt relief. It has been 25 years since Jubilee 2000, when in the millennium year various campaign and faith groups coordinated to call for the cancellation of debt to the poorest countries, which the UK government had then supported. Renewed attempts to reform NY law are unlikely to be successful, in our view, but could create a headline distraction amid strong industry resistance. In addition, the current UK Labour government was recently elected with a powerful majority in the House of Commons, leading to expectations that similar legislative proposals could be put forward, given that ‘tackling unsustainable debt’ was a campaign manifesto pledge.
    
5. Cautious on EM FX amid global uncertainties
   A shift in the US political landscape is likely to have meaningful consequences for EM countries, as the policy agenda prioritizes US protectionism and isolationism. Inevitably, we would expect both EM winners and losers. Although the Republican party’s sweep could be damaging to certain areas of EM debt, such as those countries with a higher beta to oil and commodities, we continue to see the most value in higher-spread hard-currency positions, where there is some cushion to absorb US Treasury volatility. Further supporting this view, we expect a Trump administration to favor stronger bilateral relations with certain countries with nationalist and populist leaders. With US interest rates repricing, those countries needing to refinance in the short term could be vulnerable as market access remains limited at higher rates. We expect weak performance and increased volatility in local-currency bond markets, particularly as visibility increases around the trade tariff strategy. We continue to think that the expected trade tariffs will lead to higher US and global inflation, and that global growth is likely to adjust lower as tariffs disrupt trade and investments.