EM bonds poised for stronger run

EMERGING-MARKET (EM) bonds could have more room to run in the months ahead as investors look beyond the US dollar for returns and protection against growing concerns over America’s fiscal position.

The asset class is already outperforming developed-market bonds this year, and fund managers believe the renewed “dollar debasement trade” could bring another wave of money into EM currencies and local debt.

According to a recent Bloomberg report, the shift is being driven by mounting concerns over the sustainability of US government finances and whether the dollar can continue to hold its value as a reliable store of wealth.

The resulting portfolio rotation has seen EM bonds rally alongside traditional alternatives such as gold and bitcoin.

The idea behind the so-called debasement trade is fairly straightforward: investors worry that rising US debt and deficits could eventually erode the purchasing power of the greenback, prompting them to diversify into assets denominated in other currencies.

That could be particularly supportive for EM local-currency bonds, which combine relatively attractive yields with the potential for currency gains if the dollar weakens.

“We are very bullish for what the continuation of the dollar debasement trade means for EM bonds,” Swa Wu, head of Asia ex-Japan fixed-income investment specialists at JPMorgan Asset Management in Hong Kong, told Bloomberg.

“EM central banks have proved themselves to be a lot more disciplined about inflation targeting than their developed-market counterparts,” she added.

The performance numbers underline why investors are taking another look at the asset class.

EM local-currency bonds had gained about 3.3% this year as at the end of last month, according to Bloomberg total return indexes, compared with a 1.9% decline for developed-nation bonds.

That outperformance has come despite a sharp 3.8% slump in March following the outbreak of the US-Iran war.

Compelling yield

With the US Federal Reserve’s (Fed) rate path still uncertain and US Treasury yields elevated, investors are increasingly looking for markets where monetary policy and government finances offer a more compelling combination of yield and stability.

For some fund managers, EMs now fit that bill better than the traditional developed-market bond markets.

James Athey, a money manager at UK-based Marlborough Investment Management, told Bloomberg that investors should not automatically assume developed markets offer the safer policy environment.

“I have been saying publicly for years - if I want policy orthodoxy, I go to EMs, not developed,” he said.

Athey said his fund owns neither European government bonds nor US Treasuries with maturities beyond 10 years. Instead, much of its duration is concentrated in Australia, New Zealand and EMs, including Mexico and Chile.

That positioning reflects a broader change in the way investors assess EM debt.

Many developing economies have spent years strengthening their fiscal frameworks and monetary-policy credibility after being burned by previous episodes of financial instability, including the Latin American debt crisis of the 1980s and the Asian financial crisis of 1997-98.

The result is a group of emerging economies that, in some cases, now have tighter inflation controls and more orthodox monetary policies than their richer counterparts.

That divergence could become increasingly important if concerns about US fiscal sustainability continue to build.

Rising debt

The US dollar debasement trade has gathered momentum in recent months as US national debt climbed to about US$40 trillion.

Concerns heightened in mid-August after Treasury Secretary Scott Bessent announced plans to buy back longer-maturity Treasuries, potentially limiting the return investors might expect from holding longer-dated dollar assets.

For EM debt investors, the attraction is therefore not simply about chasing higher yields.

It is also about diversifying away from heavy exposure to US assets at a time when questions over the dollar’s long-term purchasing power are becoming harder to ignore.

Wim Vandenhoeck, co-head of EM debt at Invesco in New York, told Bloomberg that the current rotation bears similarities to the shift towards non-US assets following US President Donald Trump’s “Liberation Day” tariff increases in April last year.

“Post-Liberation Day, investors favoured non-US assets when allocating portfolios, and we saw a strong rotation into EM assets,” he said.

Vandenhoeck expects that rotation to continue, arguing that “EM is both stronger and more diverse than people give it credit for.”

There is already evidence that investors have been willing to put money behind that view.

Bloomberg reported that investors poured a cumulative US$440mil into the US$5bil VanEck JP Morgan Emerging Market Local Currency Bond exchange-traded fund between April and June 2025, its biggest quarterly inflow since the first quarter of 2019.

Potential risks

Still, the bullish case is not without complications.

One of the biggest risks for EM debt is the level of US Treasury yields.

The 10-year Treasury yield has climbed in recent months to about 4.72%, according to Bloomberg, putting it within sight of the 5% level that could make dollar-denominated assets increasingly attractive again.

If US yields rise substantially from here, the incentive to move money into EMs could weaken as investors reassess the relative returns available in Treasuries.

Higher oil prices are another potential headache.

The latest increase in global energy prices is a reminder that some EM governments remain vulnerable to higher import costs and deteriorating fiscal positions.

The Fed also remains a key swing factor.

The greenback received some support last Friday after Fed chairman Kevin Warsh pledged to fight inflation, boosting expectations for interest-rate increases this year.

A more hawkish Fed could strengthen the dollar and put pressure on EM currencies and bonds.

Even so, money managers cited by Bloomberg remain constructive.

Leonard Kwan, a portfolio manager of the T Rowe Price Dynamic Emerging Markets Bond Strategy, said concerns about US debasement had revived the incentive for investors to diversify away from overweight US dollar positions and towards EM currencies and interest rates.

“We have been positively positioned” and constructive on Latin American rates, Kwan said, adding that the debasement theme provides “an additional tailwind” to that position.

For investors considering EM bonds heading into the final months of the year, the opportunity may therefore lie less in making a broad bet on all developing economies and more in identifying countries where fiscal discipline, credible central banks and attractive real yields can withstand swings in the dollar and global rates.

That leaves Latin American markets such as Mexico and Chile firmly on the radar, while local-currency debt could remain one of the more direct ways for investors to express a view that the dollar’s dominance is gradually being diluted.