Love is Blind….Is Debt?

Too often, investors give the largest, most “developed” or simply familiar countries the benefit of the doubt. Such a superficial approach, focusing on shiny labels or benchmark weights can lead to countries trading at similar levels, even when their fundamentals tell a very different story. In fixed income, where the goal is to avoid defaults and downgrades, such a bias is dangerous.

The reality today

• Global public debt hit a record $102 trillion in 2024, up 60% in a decade.

• Debt service is eating up government revenues.

• Nearly double the number of countries now run unsustainable deficits compared to two years ago.

• Many of the riskiest balance sheets belong to “safe” developed markets.

Excessive debt has real consequences. Global sovereign debt is reaching unsustainable levels, and the risks are rising quickly. Governments worldwide have issued record amounts of debt at historically low interest rates. Now, as those bonds roll over in a “higher for longer” world, many nations face mounting refinancing costs, potential distress, and spread widening across fixed income markets.

The IMF considers debt levels above 60% of GDP unsustainable for most countries. Alarmingly, the share of global GDP of the economies in this category has surged from 28% to 80% in just 2 years, as shown in Figure 2. Sovereign stress is not just a government issue - when a country runs into fiscal trouble, its corporates suffer as well.

Fundamentals matter more than labels

Markets often remain biased toward “developed market” reputations and benchmark weights, overlooking deteriorating fundamentals. Yet indicators such as debt affordability, leverage, reserves, and net foreign assets tell the real story -a story of sharp divergence. History has repeatedly shown that bonds from countries with stronger fundamentals tend to outperform in times of stress, while those from weaker sovereigns see yields spike and their credit ratings tumble.

Investors heavily rely on rating agencies to accurately assess risks, but history reveals how precarious the analysis has been and how those entities can also be influenced by labels too. Europe is a good example of this situation: pre-2008, nations were rated AAA and trading at essentially the same yields. However after a period of easy borrowing, weak fundamentals meant that some countries eventually saw sharp underperformance. Those countries had been showing worse fundamentals for a long period of time, so why were rating agencies not incorporating this into their rating? Why were investors not asking for extra compensation from those countries?

A key piece of data alongside leverage, interest cost burden and reserves is Net Foreign Assets, which we believe is key to understanding the true flexibility and capacity-to-pay of countries. When comparing this metric for the different European countries, it is clear that not all the bonds should have been trading at the same level. Investors were biased towards the “developed market” label and the shiny AAA rating, whilst ignoring or being unaware that, underneath, there was true weakness coming across. This not only impacted sovereign ratings and yields, but corporates and banks of those nations.

The biases are not limited to developed markets. A recent comparison of Peru and Turkey illustrates the point. Despite starkly different fundamentals - from inflation to debt affordability - their 5-year USD bonds traded at just a 22bp spread differential in late 2024. How much extra compensation should investors demand from Turkey to reflect its the inferior fundamentals? Stress testing is key to understanding potential outcomes. In this case, the upside was similar, but the downside for Turkey was far greater. So far this year, Peru’s total returns have nearly doubled those of Turkey, proving again that fundamentals tend to come out on top when uncertainty increases.

The lesson

As refinancing pressures mount globally, investor biases risk leaving portfolios overexposed to vulnerable sovereigns that aren’t priced for their risks. This is the moment to seek differentiated strategies that focus on true creditworthiness and to not be seduced by archaic labels, ratings, or benchmark weightings.

Love may be blind but bond markets are not as blind as they should be – and this is as true today as it was in the past. Markets get complacent in good times, but when stress hits, either at a global or a local level, fundamentals reassert themselves and investors who ignored them pay the price. Higher yields don’t always mean higher returns. So in the current market environment, where spreads are tight, and risk premia is limited, focusing on fundamentals is key in our view.

Debt isn’t blind. Many investors still are. That’s our opportunity.

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