• An uncertain macroeconomic backdrop characterised by slower growth due to tariffs and other uncertainties, along with very tight EM corporate debt valuations, means we now favour EM sovereign debt over EM corporate bonds.
  
  
• EM sovereigns offer a combination of higher spreads and longer durations than EM corporates, which offer improved downside mitigation in periods of market stress and risk-off sentiment.
  
  
• EM sovereign bonds have better liquidity profiles and higher default recovery rates than EM corporates.
   

A shift in emerging market fixed income strategies

In August 2022, amid a difficult year for emerging markets (EM) and risk assets more broadly, Vanguard made the case for EM corporate debt, citing strong fundamentals and attractive valuations. However, we now believe that the outperformance of EM corporates over EM sovereign credit has run its course.

EM corporates have outperformed their sovereign counterparts since 2022, supported by a combination of greater spread compression and a shorter duration profile.

Total return for EM corporate bonds compared with EM sovereign debt

Source: Bloomberg, for the period 1 January 2022 to 31 March 2025. Indices used: EM sovereigns: J.P. Morgan EMBI Global Diversified Index; EM corporates: J.P. Morgan CEMBI Global Diversified Index.

We believe we are entering a new macroeconomic regime characterised by slower growth due to tariffs and other uncertainties, while EM corporate valuations have reached very tight levels. Here we explore the potential benefits of investing in EM sovereign debt relative to EM corporate bonds.

EM sovereign debt offers higher spreads and longer duration than EM corporates

EM sovereigns currently offer a unique combination of higher spreads and longer duration relative to EM corporates, with an attractive all-in yield of 7.78% and a duration of 6.6 years¹ – giving EM sovereigns an edge over EM corporates during periods of market stress and risk-off sentiment.

In contrast, EM corporates offer a lower all-in yield of 6.77% and a shorter duration of 4.2 years², with less spread compression potential.

Option-adjusted spreads and durations for various types of debt

Source: Bloomberg, as at 19 March 2025. Indices used: US high yield: ICE BAML US High Yield Index; European high yield: ICE BAML European High Yield Index; European investment grade: Bloomberg Euro Aggregate Corporates Index in EUR; US investment grade: Bloomberg Global Aggregate Corporates US Dollar Index; EM hard currency sovereigns: J.P. Morgan EMBI Global Diversified Index; EM corporates: J.P. Morgan CEMBI Global Diversified Index.

When interest rates were rising, the shorter duration profile of EM corporates benefitted investors. However, we believe this structural tailwind is now behind us, and we now favour exposure to longer-duration assets such as EM sovereigns.

Fundamentals shift?

Before the Global Financial Crisis, the private sector was highly leveraged, leading to significant vulnerabilities within financial markets. In response to the economic turmoil that ensued, the public sector—through sovereign balance sheets—intervened to stabilise economies via quantitative easing and extensive bailouts. This period saw a revival of financial repression—that is, artificially suppressing rates to lower debt-burden costs—as governments worldwide implemented strategies to stimulate the private sector. Since 2008, we have witnessed central banks and governments implementing a range of measures designed to foster corporate investment and economic recovery, including:

• Quantitative easing
• Ultra-low interest rates
• Fiscal stimulus
• Credit facilities

These measures led to a significant improvement in the overall quality of corporate balance sheets over the past decade. However, we believe there is the potential for structural change as the pendulum swings from strong corporate balance sheets to stronger sovereign balance sheets.

Since the end of the Covid-19 pandemic in 2021, EM sovereign fundamentals have been improving, with upgrades outpacing downgrades among EM sovereign issuers at a rate of 2:1 in 2024³ – the highest ratio in ten years.

When we look at EM corporates, while balance sheets remain healthy, optimism has likely peaked. Sectors such as energy, industrials, automotives and chemicals have been deteriorating due to the economic slowdown in Europe and overcapacity in China, which is adding leverage and putting pressure on prices.

The new tariffs implemented by the US administration have only added to these challenges, raising the critical question: will EM firms absorb the extra costs of the tariffs, or will they pass them along to consumers through higher prices?

Recent data from the US suggest consumer confidence is waning—which could make it more difficult for companies to pass along the costs of tariffs through higher prices, potentially putting pressure on EM firms’ profit margins and leading to a deterioration in EM corporate balance sheets. 

EM corporates look expensive relative to historical averages and EM sovereigns

Currently, EM corporate spreads are trading at historically tight levels – while EM sovereign debt spreads are priced closer to their long-term averages.

As EM corporate valuations have compressed at a faster rate than their sovereign counterparts, the spread differential between the asset classes has increased over the last 15 years—leading to sovereign debt looking more attractively priced, on a relative-value basis, in the current market.

Historical spread differential between EM sovereigns and EM corporates

Source: Bloomberg, for the period 1 January 2022 to 31 March 2025. The chart shows the spread-to-worst differential, in bps, between EM sovereigns and EM corporates. Indices used: EM corporates: J.P. Morgan CEMBI Broad Diversified Index; EM sovereigns: J.P. Morgan EMBI Broad Diversified Index. Calculations in USD. 

Sovereigns offer a better liquidity profile

While the liquidity profiles of EM sovereigns can vary widely, EM corporates do not usually benefit from the same level of liquidity as EM sovereigns.

EM sovereign issuers typically have well-developed bond yield curves with large issues at varying maturity points. A typical EM sovereign issuer has six bonds outstanding, with an average issuance size of approximately $1.2 billion. Meanwhile, the average EM corporate issuer has two bond issues outstanding, with an average issuance size of approximately $600 million.

In the event of a sell-off, EM corporates can face greater liquidity challenges than EM sovereigns. At current valuations, we do not believe that investors are being fully compensated for the additional liquidity risk of EM corporates.

Different default dynamics

Both EM sovereigns and EM corporate issuers might be subject to periods of distress that lead to large drawdowns and, in some case, defaults. Although we do not anticipate an increase in defaults in either space, it is worth highlighting the differences in default dynamics and recovery rates between the two asset classes.

EM sovereign defaults tend to be slower and more predictable, often stemming from prolonged economic mismanagement, and EM sovereign issuers usually have access to multilateral aid and additional time to work out a solution with their creditors. Corporate defaults, on the other hand, can be sudden, triggered by company-specific risks such as fraud or governance issues.

Since 2008, EM sovereigns that have entered default typically had higher recovery rates (56%) compared with EM corporates (34%), primarily due to multilateral support and more standardised resolution processes, whereas corporate defaults involved more legal complexities.

Comparing default and recovery rates for EM corporates and EM sovereigns

Source: JP Morgan. Default and recovery data for EM corporates are for the period from 2008 to 2024; data for EM sovereigns are for the period 2008 to 2023.

An attractive long-term opportunity

Given the current macroeconomic environment, characterised by slower growth and tight EM corporate valuations, we believe a broad exposure to EM sovereigns offers investors a better chance of long-term investment success, providing better valuations, higher liquidity and improving fundamentals when compared with EM corporates. 
 

¹ Source: Vanguard and Bloomberg. Yield and duration calculations are as at 31 March 2025.

² Source: Vanguard and Bloomberg. Yield and duration calculations are as at 31 March 2025.

³ Source: Vanguard and Bloomberg, as at 31 December 2024.
 

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