Artisan Canvas

When the Music Stops at the High Yield Party

In a world where uncertainty outweighs certainty, EM credit spreads have defied expectations, grinding tighter despite persistent macro risks. Since mid-2022, spreads have steadily narrowed, recently reaching their tightest levels since February 2020—just weeks before the global COVID-19 sell-off. While EM debt benchmarks have ridden the wave of broad credit spread tightening, their market-cap-weighted methodology has resulted in a significant allocation to low-spread securities, leaving the benchmarks with one foot in and one foot out of the party.

This latest period of spread compression has disproportionately favored lower-rated issuers over investment-grade (IG) names. In 2024, EM high yield (HY) outperformed EM IG by nearly 13%, the greatest annual performance differential between the two segments of the J.P. Morgan EMBI Global Diversified Index since the GFC. Within high-yield, C-rated issuers led the rally, outperforming B- and BB-rated bonds by 38% and 47% in 2024.

In addition to existing allocation challenges, benchmarks could face even more pain if the rally reverses and credit spreads widen, especially given how their allocations have evolved in recent periods. On the other hand, an active approach to investing in emerging markets debt can help investors avoid these pitfalls. Even with historically tight spreads, active investors can identify unique opportunities that offer potential returns. Investors can strategically position portfolios to capitalize on undervalued countries that continue to progress with reforms while avoiding those where key risks could drive credit spreads wider. After all, when the music stops at the high-yield party, only investors with the right positioning will have a seat.

Behind the Scenes of the Credit Rally

In our view, the recent period of spread compression is being driven by three key factors:

• Structural policy reforms: Some countries have implemented policies that can strengthen credit fundamentals, including consolidating fiscal balance and enhancing business environments.
• Multilateral support and successful debt restructurings: Increased funding from the IMF, World Bank and allied nations has helped certain countries stay out of default. Additionally, successful or ongoing debt restructurings in several countries have bolstered investor confidence.
• Robust global growth: A resilient global economy has supported risk appetite.

Several countries have been at the forefront of this rally, benefiting from structural reforms, geopolitical shifts and investor optimism. For example, Argentina, buoyed by President Javier Milei’s sweeping fiscal reforms, has delivered bondholders a 103% return in 2024. In Ukraine, optimism surrounding a potential resolution to the war, coupled with the successful restructuring of approximately $20 billion in international bonds, has fueled a 63% return for 2024. Sri Lanka’s dollar bonds have climbed 25% following the successful restructuring of its external debt, a crucial milestone in its path out of extended default. Ecuador has generated 71% returns in 2024 after completing its second debt-for-nature swap, using the proceeds to retire outstanding bonds. However political uncertainty in the country has reversed some of these gains in recent weeks. Meanwhile, Pakistan’s newly formed government wasted no time in restoring macroeconomic stability—securing an improved IMF deal, getting inflation under control and spurring a growth rebound—all of which have propelled its dollar bonds 43% higher in 2024.

The Benchmark Trap

The recent high yield rally and growing divergence within the asset class underscores several of the challenges with emerging markets debt benchmarks—or several of the Seven Deadly Sins of EMD Benchmarks, as discussed in our most recent whitepaper. One is that the benchmark’s market-cap weighted method assigns higher allocations to countries with more debt outstanding, regardless of fundamentals or valuations. A consequence of this approach, and a second deadly sin, is that nearly half of the J.P. Morgan EMBI Global Diversified Index was allocated to bonds with spreads below 150bps in 2024 during the rally. These low-spread bonds are primarily rated AA- and A- and saw little movement in their credit spreads throughout the year, yielding returns of 0.18% and 0.98%, respectively. While the benchmark also had exposure to bonds from countries leading the high-yield rally, its substantial exposure to low-spread securities weighed on overall performance.

Adding to the challenge is how the benchmark’s allocation has evolved in recent years, potentially creating further headwinds if the rally reverses. Its high-yield exposure is now at its highest level since 2018, just as credit spreads tighten to multi-year lows. While compelling opportunities remain in high yield, broadly increasing risk amid heightened uncertainty and tight valuations seems imprudent.

J.P. Morgan EMBI Global Diversified Index: Non-IG Spread vs. Non-IG Weight in the Index

The Active Advantage:

We believe an active approach to investing in emerging markets debt can help navigate around the benchmark’s limitations and allow investors to dynamically adjust positioning based on conviction rather than market capitalization. In the current market environment, our outlook on emerging markets debt has turned even more cautious amid intensifying geopolitical risks and increased uncertainty surrounding the new Trump administration.

Nonetheless, certain countries continue to progress with reforms and present compelling opportunities with attractive valuations despite overall tight spreads. An active approach to the asset class that focuses on bottom-up research can identify these compelling opportunities early and understand how an important policy moment may alter the trajectory of a country or significantly change asset risk premiums. Without the limitations of a benchmark, an active approach can seek to capture the best opportunities within the emerging markets debt space and dynamically adjust based on risks and opportunities in the current market environment. On the other hand, EMD benchmarks —constrained by their methodology — may find themselves without a seat when the music stops at the high-yield party.