Will spreads in Emerging and Developed Markets converge again?

Historical context and recent divergence

Investment grade-rated (IG) corporate bonds from developed market (DM) issuers and IG sovereign bonds from emerging market (EM) issuers have historically demonstrated a high positive correlation, with EM bonds typically offering higher yields for comparable volatility levels. However, during 2023-2024, this relationship diverged significantly. While DM IG corporate bonds experienced spread tightening for two consecutive years, EM IG sovereign spreads remained relatively stable.

Understanding the divergence

The relative underperformance of EM IG sovereign bonds can be attributed to multiple factors. Geopolitical uncertainties and U.S. dollar strength disproportionately impacted EM credit spreads, with EM issuers facing greater exposure to currency volatility and global growth concerns. Notably, EM sovereign High Yield delivered exceptional returns in 2023-2024, with spreads in the C-rated category declining by more than 1,000 basis points, suggesting specific rather than broad macro factors at play.

EM IG sovereigns outperformed in 2022 as rising interest rates had a more substantial impact on DM corporate growth. Investors reducing duration risk created a challenging technical backdrop, while concerns about U.S. financials and real estate, triggered by Silicon Valley Bank and Credit Suisse events, led to EM IG sovereigns trading at levels comparable to or tighter than DM IG corporates throughout 2022-2023.

The 2024 trend shifted with rate cut expectations and decreasing recession probability. Post-pandemic deterioration in government balance sheets and deficit concerns contrasted with generally healthy corporate balance sheets. Specific events impacted IG EM spreads, such as Panama's spread widening of over 100 basis points since November 2023, while Mexican and Romanian elections introduced volatility as investor focus shifted to weakened domestic fundamentals.

Outlook for 2025

The risk premium for IG EM sovereign spreads has returned to elevated levels compared to historical averages. A convergence scenario could develop through a stable macro environment combined with attractive yield differentials, greater clarity on U.S. trade policy and interest rates, and political stabilization in key EM countries.

U.S. corporate spreads appear tight by historical measures, and an economic slowdown could impact cyclical U.S. corporates more significantly than EM fundamentals. High-quality EM bonds have demonstrated resilience during periods of growth uncertainty, potentially offering defensive characteristics in challenging market conditions.

Source: EFGAM: Bloomberg, as at 31/12/24

Past performance is not a guarantee of future performance.

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