Emerging market (EM) debt has returned to the center of investor discussions following solid performance. The question now is whether this performance can be sustained over time. We believe that maintaining solid performance depends on two conditions: the presence of plausible arguments in favor of a stable or declining US dollar, which supports inflows into this asset class, and a mix of steady growth and inflation in emerging markets that favors policy flexibility.
We believe these two conditions can be met in the medium term. Under such conditions, we see strong potential for emerging market debt – particularly local markets – to offer investors solid and diversified sources of return.
The Weakness of the US Dollar Plays a Key Role
The US dollar often represents the most relevant macroeconomic variable for emerging market debt returns, as it influences both financial conditions and investor behavior. A weaker dollar tends to support emerging market currencies and sovereign balance sheets with external liabilities. It can also encourage investors to diversify their portfolios away from US assets toward non-US opportunities, including emerging markets, especially when valuations and yields appear more attractive.
History shows that dollar cycles can last for years, driven by growth and interest rate differentials, as well as changes in global risk appetite. If the strong dollar headwind that challenged emerging market assets from 2022 to 2024 continues to dissipate, we would expect a more favorable environment for emerging market debt, particularly local currency bonds.
The Macroeconomic Strength of Emerging Markets
The improvement in macroeconomic fundamentals constitutes the second pillar of the argument in favor of emerging market debt. Many emerging economies today boast more credible monetary frameworks than in previous decades, and some faced the recent global inflation shock having already tightened monetary policy promptly and decisively.
With inflationary pressures easing after the 2022 peak, policymakers have been able to stimulate a growth boom rather than merely defending currency stability. For bond investors, moderating inflation and high real interest rates create potential for capital gains if benchmark rates decline, while also offering attractive carry. Moreover, several emerging markets have improved fiscal discipline and current account management compared to past cycles, and many maintain adequate reserves and more manageable debt profiles than the emerging market fragility stereotype would suggest.
These improvements are not universal, but the overall trend is positive. Structural macroeconomic factors also strengthen medium-term prospects. Demographics remain a favorable factor in parts of the emerging world, for example, where a young and rapidly growing workforce supports consumption, urbanization, and productivity gains over time. This does not guarantee strong growth – politics, governance, and capital formation remain important – but favorable demographics can make growth prospects more resilient compared to aging developed economies facing higher dependency ratios. Additionally, an increasing number of emerging economies are becoming more diversified, driven by robust service sectors and domestic demand, compared to past reliance on commodity exports.
However, exports continue to play an important role and represent a positive growth driver, particularly technology exports. Even amid significant global trade tensions, emerging market exports have remained solid.
Local Currency vs Hard Currency
Within the emerging market debt landscape, it is important to distinguish between local currency and hard currency asset classes, as the factors determining returns and risks differ. Local currency bonds offer two potential sources of return: local yields and currency appreciation. In a scenario where the dollar is weak and emerging market currencies appreciate or remain stable, local bonds have the potential to generate substantial total returns. Local markets can also benefit from internal disinflation and monetary easing, especially when real rates start from high levels. The trade-off, however, is the currency volatility that local currency exposure can entail: currencies can suffer sharp declines during global risk shocks, even when local interest rates perform well.
Emerging market hard currency debt — typically issued in US dollars — plays a different role in investment portfolios. Although dollar-denominated, a weaker dollar supports emerging market hard currency debt by improving a country’s fundamentals: a weaker dollar makes emerging market exports more competitive and reduces the value of a country’s dollar-denominated debt. Emerging market hard currency debt can also offer attractive yields and be easier to integrate into global bond portfolios, since the currency is the same as the investor’s base currency. In periods of stable risk sentiment, hard currency bonds can offer steady carry and benefit from declines in US interest rates.
However, upside potential is often more limited when spreads are already tight; there is less room for spread compression to drive returns, and asymmetry can worsen if global conditions deteriorate and spreads widen. In this sense, emerging market hard currency debt can be best considered as an income-oriented exposure with sensitivity to global credit conditions, while local currency can offer greater upside optionality in a weakening dollar environment but entails potentially higher volatility.
Risks
The most obvious risk for emerging market debt is a reversal of the dollar’s downward trend and a return to dollar strength. If US growth were to accelerate again, inflation proved persistent, or the Federal Reserve maintained a tighter monetary policy for longer than expected, the dollar could strengthen and financial conditions in emerging markets could tighten. In such a scenario, the higher yield offered by local currency debt could be offset by currency headwinds, and hard currency spreads could widen if risk appetite deteriorates.
A second key risk is geopolitical and commodity price volatility. For some emerging economies, commodity price swings are a determining factor for budget balances and external positions, and geopolitical shocks can trigger sudden risk repricing. A third risk is country-specific political credibility. Emerging markets are heterogeneous: some countries have strong institutions and consistent policies; others are more vulnerable to political uncertainty, fiscal deviations, or external financing needs. Country selection, diversification, and portfolio risk control are therefore crucial, especially when investors venture beyond higher-quality sovereign bonds.
Emerging Market Debt Return Profile
Finally, we believe it is important to consider the dispersion of returns within emerging market debt. Many investors view emerging markets as a single asset class or a homogeneous group. However, the opposite is true. Emerging market debt includes over 70 countries across five distinct regions, with extremely diverse economic, political, and legal structures. Dubai is very different from Brazil, Nigeria from Costa Rica, and China from Poland.
This wide variability contributes to the significant diversification benefits offered by the asset class but also strengthens the case for active management over a passive approach. To illustrate the significant return dispersion recorded over the past 12 months in the hard currency segment, Venezuelan sovereign bonds generated a 138% return, while Senegalese debt declined by more than 13%, and Chinese and Indonesian bonds posted returns between 6% and 7%.1 Local currency emerging market debt shows similarly wide dispersion: the asset class returned 19% over the past 12 months, and during that period, returns ranged from low single digits for India (+2.4%) to very high double digits for South Africa (+47%) and Mexico (+37%).2 The point is that the breadth and diversity of the asset class result in wide return dispersion, creating significant potential opportunities for active management.
Conclusion
We believe emerging market debt represents a valid medium-term option for investors. This asset class offers a credible mix of income, diversification, and potential capital appreciation at a time when developed market fixed income faces less favorable starting conditions. While the US dollar trend is an important factor, the overall driver backdrop appears favorable: improving macroeconomic stability in many emerging countries, high real yields in some areas of the emerging market opportunity set, and the likelihood that global portfolios will continue to increase allocations to non-US assets.
Within emerging market debt, we believe local currency debt represents the best opportunity. If the weakening dollar environment persists, local bonds should benefit from yields available in domestic markets and further upside potential from the strength of emerging market currencies in US dollar terms.
Slowing inflation and policy flexibility can provide additional support through lower local interest rates. While emerging market hard currency debt also represents a useful complement for income- and diversification-oriented exposure, medium-term return opportunities in emerging market local markets appear more asymmetric, allowing rates and currencies to act in synergy to potentially generate higher total returns.
