Emerging Market Sovereign Debt in 2026: Opportunity Behind the Risk Premium

Emerging market economies grew 4.1 percent in 2025, comfortably above the 1.6 percent rate in developed markets. The growth differential of 2.5 percentage points is near its 20-year average, suggesting that the ‘EM premium’ in economic activity remains intact despite geopolitical headwinds and China’s structural slowdown.

The growth was driven by three factors: (1) commodity-exporting economies (Brazil, Saudi Arabia, South Africa) benefiting from elevated oil, copper, and gold prices; (2) manufacturing beneficiaries of supply chain diversification (Vietnam, Mexico, India) capturing investment diverted from China; (3) domestic consumption growth in large populations with rising middle classes (Indonesia, Philippines, Egypt).

Inflation has fallen sharply across most EM economies. The median EM inflation rate declined from 6.8 percent in 2023 to 3.9 percent in 2025, enabling widespread monetary easing. Seventeen EM central banks cut rates in 2025, with Brazil (-200bps), Chile (-300bps), Hungary (-250bps), and Poland (-150bps) leading the easing cycle. Real policy rates remain high by historical standards, providing room for further cuts in 2026.

The JP Morgan EMBI Global Diversified index — the benchmark for EM hard-currency (USD-denominated) sovereign bonds — trades at a spread of 320 basis points over US Treasuries, down from 410 basis points in October 2023 but above the pre-COVID average of 280 basis points. This implies an average yield of 6.8 percent (US 10-year at 4.2% plus 320bps spread), offering significant carry relative to developed market bonds.

The compression in spreads has been driven by improved fundamentals, decreased default expectations, and the global search for yield as DM central banks cut rates. However, the compression is not uniform: investment-grade EM sovereigns (Mexico, Indonesia, Chile) trade at 100-150bps over Treasuries, while frontier markets (Ethiopia, Pakistan, Sri Lanka) trade at 600-1,200bps, reflecting genuine credit risk.

Local-currency EM bonds offer a different risk profile. The JP Morgan GBI-EM index (local-currency sovereign bonds) yields approximately 6.2 percent with an additional potential return from EM currency appreciation. In 2025, the Brazilian real appreciated 8 percent, the Mexican peso 5 percent, and the South African rand 12 percent against the US dollar, adding to total returns for unhedged investors.

Brazil (BBB-, positive outlook). Brazil’s SELIC rate has been cut from 13.75 percent to 10.50 percent, with further easing expected. The 10-year local bond yields 11.2 percent with core inflation at 3.8 percent, providing a real yield of 7.4 percent — among the highest in the world. The risk is fiscal: public debt-to-GDP is 78 percent and the primary deficit is 1.5 percent of GDP. President Lula’s fiscal framework has been questioned but has so far held.

Mexico (BBB+, stable). Mexico is the prime beneficiary of nearshoring and friend-shoring as US companies diversify supply chains from China. FDI reached $38 billion in 2025, a record. Local bond yields are 9.8 percent with inflation at 4.2 percent. The risk is political uncertainty under the new administration and the 2026 USMCA treaty review.

Indonesia (BBB, positive outlook). Indonesia is the ‘Goldilocks’ EM sovereign: 5.1 percent GDP growth, 2.8 percent inflation, a current account near balance, and a debt-to-GDP ratio of only 39 percent. The 10-year rupiah bond yields 6.5 percent, with Bank Indonesia’s gradual easing supporting bond prices.

South Africa (BB-, stable). The inclusion of the Democratic Alliance in a coalition government has been credit-positive. The rand appreciated 12 percent in 2025, power outages (‘load shedding’) have decreased 80 percent, and mining output is recovering. The 10-year bond yields 10.8 percent, but structural unemployment at 32 percent remains a long-term drag.

The post-pandemic wave of EM sovereign distress is gradually resolving. Sri Lanka, Ghana, Zambia, and Ethiopia all entered debt restructuring between 2022 and 2024 under the G20’s Common Framework. By early 2026, outcomes are mixed:

Sri Lanka’s restructuring was completed in September 2025 with bilateral creditors accepting 28 percent nominal haircuts and Eurobond holders receiving GDP-linked warrants. The country has returned to 3.2 percent growth and regained access to bilateral financing, though market access remains limited.

Ghana completed its domestic debt exchange in March 2024 and Eurobond restructuring in September 2025, with bondholders taking a 37 percent NPV loss. The cedi has stabilised and the cocoa economy supports fiscal recovery, but implementation of IMF conditionality is behind schedule.

Zambia’s restructuring — the first under the Common Framework — took 38 months, highlighting the dysfunction of the current sovereign debt architecture. The final deal, completed in November 2025, provided a 20 percent haircut with maturity extensions. Copper-driven GDP growth of 5.8 percent is supporting recovery.

The lesson for investors is that EM sovereign defaults, while disruptive, typically result in recovery rates of 40-60 cents on the dollar, compared to 20-30 cents for corporate defaults. Patient, distressed-focused investors have generated 25-40 percent returns on post-restructuring bonds by buying the panic and holding through recovery.

No discussion of EM debt is complete without addressing China, the elephant in the room. China’s structural slowdown (GDP growth of 4.2 percent in 2025, the lowest since 1990 excluding COVID) has both positive and negative spillovers for other EM economies.

Negative spillovers include reduced demand for commodity exports (iron ore, copper, oil), competitive pressure from cheap Chinese manufactured goods flooding global markets (particularly EVs and solar panels), and contagion risk if China’s property sector distress intensifies.

Positive spillovers include supply chain diversification benefiting Vietnam, India, Mexico, and Indonesia, reduced global inflationary pressure from Chinese deflation (PPI at -2.5 percent), and potential for China’s monetary stimulus to boost regional demand in the second half of 2026.

For EM bond investors, the key distinction is between ‘commodity EM’ (exposed to China demand) and ‘manufacturing EM’ (benefiting from China substitution). Brazil, Chile, and South Africa are in the first camp; Vietnam, Mexico, and India are in the second. A diversified EM bond portfolio should have exposure to both themes.

For institutional and retail investors seeking EM bond exposure, the trade-offs are between hard-currency (USD) and local-currency bonds, investment-grade and high-yield, and direct bonds versus ETFs and mutual funds.

Hard-currency bonds eliminate FX risk but cap upside when EM currencies appreciate. They are also more correlated with US Treasuries and less ‘EM’ in character. Local-currency bonds capture the full EM opportunity (high real yields plus potential FX appreciation) but add volatility — the standard deviation of GBI-EM returns is 11 percent versus 8 percent for EMBI Global.

The most efficient vehicle for retail investors is a diversified ETF: iShares JP Morgan USD EM Bond ETF (EMB, $18B AUM, expense ratio 0.39%) for hard-currency, or VanEck JP Morgan EM Local Currency Bond ETF (EMLC, $4B AUM, 0.30%) for local-currency. For more sophisticated investors, a blend of 60 percent hard-currency and 40 percent local-currency has historically optimised the risk-return trade-off.

Risk management is essential. EM bonds can have severe drawdowns: in 2022, EMBI lost 17.8 percent and GBI-EM lost 11.7 percent. Position sizing should reflect this: a 10-15 percent allocation within a diversified fixed-income portfolio is appropriate for most investors, with higher allocations only for those with long time horizons and strong stomachs.