Why Hard Currency Emerging Market Debt is Back in Focus

Why Hard Currency Emerging Market Debt is Back in Focus

Anu Rajakumar: For years, emerging market debt has been stress tested by a strong US dollar, high global rates, and uneven post-pandemic recoveries. Now with rates coming down and the dollar softening, EMD and especially hard currency bonds are back in focus, standing out in many cases for offering attractive yields and diversification. Can we say EMD has passed its stress test? Technicals and fundamentals certainly show signs of improvement, but how robust are balance sheets after years of tight financial conditions, and how aligned are fiscal policies?

Where are the potential pitfalls, and where are the most attractive opportunities? For investors, is now the time to consider adding or increasing an allocation to EM debt in your portfolio?

My name is Anu Rajakumar, and joining me today is portfolio manager Gorky Urquieta to share his perspective on how to think about hard currency, EM exposure, what's driving returns, how to navigate risk, and practical ways to allocate to this asset class. Gorky, welcome to the show.

Gorky Urquieta: Thank you for having me, Anu.

Anu: Gorky, let's start. For those who are new to the space, with just a basic definition, how would you define hard currency emerging market debt? Tell us how it differs from local currency emerging market debt, and how do these distinctions shape risk and return, especially in the current market context?

Gorky: When we say hard currency, we're typically referring to sovereign and quasi-sovereign debt, bonded, issued in dollar, or other reserve currencies. Typically, it's essentially a US dollar universe. The difference between this universe of hard currency and local is that there's no direct FX risk, unlike in local currency, where you're effectively investing in local currencies or local rates. In hard currency, it's the country credit that is the dominant risk, and we're looking to benefit from the carry.

There are also very different universes when we think about the sovereign hard currency universe and the local universe in terms of the country composition, for example, Latin America is the heaviest one, the largest one in hard currency. It has about a 36% representation in that universe, whereas in local, it's actually Asia that is the heaviest with almost 48%. This distinction is also important because they have very different risk profiles.

Now, from an investor lens, I guess you think about an intermediary type of perspective. Probably the easiest way to think about hard sovereign is in the context of US IG high-yield credit, because they are also, of course, dominated by credit risk. It's also a universe that actually sits in the middle of these two US IG and US high yield. On average, the sovereign universe's hard currency is BB+, but it's effectively literally split 50/50. 50% is investment rate, and the other 50% is high yield. It will typically fall within these two US credit universes. Maybe the last thing I'll say, Anu, is that there are such significant credit quality dispersions.

I mentioned the universe is high yield and IG, but even within that, we're talking about 70+ countries that are represented in the universe, and we have a spectrum of credit quality all the way from AA+ to a couple of countries that are in default.

Anu: Great. Maybe just one clarifying question. You said between a hard currency and local currency, there are different regional concentrations, hard currency being a little bit more Latin American-oriented and local being more Asian-oriented. Could you explain why that is? Again, is there any credit quality differences between those regions that investors might not be aware of?

Gorky: It's a little bit the representation. The rules for the benchmarks are a little bit different, but when it comes to local markets, GBI, which is the benchmark that most investors use in local space, local EM, it's dominated by a couple of large Asian economies countries like India, China, Indonesia. They're pretty much at an element of 10%. Now, these same countries that I just mentioned have very little external debt, and they have very low representation in the hard currency universe.

They're also high quality. They tend to be much, much less dominant from a risk perspective. When we talk about hard currency sovereigns, I mentioned Latin America remains the heaviest region. Here, we have a couple of heavyweights. We got Mexico, Brazil, Argentina still fairly a large component of that benchmark. If we were to make that distinction, those are probably the countries that are more representative of their respective universes.

Anu: Great. Thank you for that. Now, as we're thinking about allocations today, investors are certainly-- They have tariffs and global trade tensions on their minds. How should investors weigh up those concerns when assessing sovereign EMD risk?

Gorky: It's undeniable that the whole tariff conversation, discussion, is creating a lot of uncertainty and is going to be disruptive. It's already being disruptive to some degree, impacting global growth and trade broadly. Having said that, emerging economies so far, by and large, have been able to navigate this relatively well, and I'm going to get back to the two different universes here.

In the case of the hard currency, again, like Asia, heavy LatAm to pick on the two extremes, when we think about the pace and the level of tariffs that have been applied and how those tariffs were determined, they've been applied mostly against countries with which the US has large trade deficits. These are mostly countries in Asia. I'm talking about countries like Taiwan, Vietnam, Thailand, South Korea. None of these countries are represented in the hard currency universe.

In Latin America, with the exception of Mexico, Mexico does have a large trade surplus with the US, Mexico still operating within the USMCA context that's going to be negotiated or renegotiated in 2026. Mexico has not suffered the imposition of these new tariffs. In Latin America, most of the countries in the region actually have trade deficits with the US. As a result, they've also been applied the baseline tariffs of 10%. There are a couple of situations, like Brazil, where potentially there's a 50% tariff applied because of issues that are not really related to trade.

Finally, a lot of these non-Asian countries are actually pretty closed economies, meaning that their trade is not that significant relative to their GDP, and the US tends to be a relatively small part of that. I'm not suggesting to say that they're insulated from all of this, but they're not directly as exposed. Finally, by the nature of the economies, countries, of course, will see the impact of tariffs but mostly indirectly. It's in the corporate credit, universal corporates that the tariff impact will be more direct.

A lot of these economists are very reliant on commodity trade and exports, for example. Those tend to escape the core nature of the tariff that's been applied. It's mixed and so far has not been very detrimental, but we have to acknowledge that there will be a level of uncertainty that will be with us for a while, more likely.

Anu: Yes, absolutely. That's super helpful to know. Maybe just along those lines, let's also talk about dollar dynamics and the US rate cycle. What influence does that have on the emerging market debt opportunity set?

Gorky: That's a very interesting question. We are in the middle of a cycle where we've been with a US dollar that's been on a weakening trend after having been on a revaluation trend that started roughly around 2014. We call it the US dollar supercycle that ended probably early this year. That's one item. The other one, of course, the face of where the Federal Reserve is in terms of the easing of monetary policy. Historically, when we've had the combination of these two, a weak or weakish dollar and a Fed that's cutting rates or monetary policy that's on an easing mode, historically, that has been fairly positive to emerging markets.

It's a bit of a tailwind for a couple of reasons. One, a weaker dollar actually eases financial conditions for sovereign debtors because essentially they have to repay their external debt in US dollars. A cheaper USD means that their countries are stronger. It's easier for them to acquire those dollars to repay their external debt. That's one channel. The other one, of course, with lower rates, financial conditions ease broadly and also benefits most of these economies. We suspect that there remains significant amount of horizon for this window to continue to play out. We are already seeing some of that if we judge by how EMD has performed in 2025 so far, at least.

Anu: Great. Thank you for that, Gorky. Now, emerging market debt is known for idiosyncratic country stories. I was going to ask if you could share a good example of how policy shifts or elections can shape sovereign credit risk and how an active approach might be able to navigate that complexity.

Gorky: An active approach makes a lot of sense here because, as we've just seen in the event of the Argentine midterm election, these political events can drive risk in a very significant way, positive or negative. When you have an active management approach, essentially, where you're providing deep research and you have a deep research platform and expertise, you can size these types of events.

Of course, I'm not suggesting that you're always going to be able to anticipate the outcome, but we do know that outcomes can sometimes be binary. We also had a similar example in the case of Ecuador with the election in the second-round presidential election back in April. That wound up being a very positive outcome in the sense that the sitting president, pro-reform, pro-market president got reelected with a significant amount of support.

We've seen the market perform very well since as it consolidated the approach and program with the IMF process of reforms, et cetera, et cetera. Again, risk controls will be part of how we manage these types of country events, that many times are going to be dominated by political and electoral events.

Anu: Maybe just a follow-up to that. Have there been times in recent history where liquidity has suddenly become an issue with a particular market that was unexpected?

Gorky: That's a great question. This is actually a universe that is pretty liquid. Of course, we can point to events, I'm thinking early COVID, maybe February, March of 2020, when the whole market everywhere ceased, froze, where in those very extreme events of risk of or uncertainty, the markets become less liquid. We do have a benefit, which is many of the countries where we invest in, they actually have significant domestic investors. Then they tend to be active.

This is actually what happened in early COVID when things froze, many of the markets represented in our universe actually had better liquidity because their domestic players, I'm thinking here, for example, of countries in the Gulf, the GCC, where a big chunk of their bonds, their external debt is actually held by domestic investors. A lot of the securities continued to provide pretty good liquidity in spite of the broader markets being stretched.

Of course, in some of the higher-yielding, higher-risk countries, when there are specific idiosyncratic events, and we will see the bid-ask, the levels of prices in the bonds widen, but typically they tend to mean-revert fairly quickly. We'll have windows of less liquidity or less liquid conditions, but they don't tend to be long-lasting. That's an interesting feature that EMD does have. Again, we compare BDAs levels or spreads. The average, for example, for the sovereign universe is roughly between 1/2 a point to 5/8 of a point.

It's fairly liquid. We also have large issues. Countries represented in the benchmarks many times have multimillion or more multi-billion dollar-sized bond issues, which also helps in terms of liquidity.

Anu: Excellent. No, thank you so much for sharing that. Now, you mentioned this earlier, you said hard currency, emerging market debt often sits in between US investment grade and high yield. I want to ask you to expand on that a little bit more. Tell us about where EMD sits in terms of yield, duration, quality, and how should our listeners be thinking about this allocation from a portfolio construction perspective?

Gorky: As we briefly talked earlier that this part of the universe is very fairly comparable to US high yield. If we think about the yield proposition today, for example, the sovereign external debt universe has a yield-to-maturity of almost 7%, which is very, very similar to US high yield. However, this is a universe that is better quality from a credit perspective, it's BB+ on average, versus B+ for US high yield.

Having said that, it also has longer duration, so it's not quite apples to apples. If we dissect and compare investment-grade sovereigns with US IG credit, you do get a pickup in the yield or spread. As much as that differential has converged in 2025, there's still some pickup, but in the high yield universe, we compare sovereign external debt high yield versus US high yield credit. The differential is still fairly meaningful. We're talking about 150, 160 base points of yield differential.

This is a way to think about our space. It has longer duration, but it's a better quality universe. We're talking credit risk, where care is going to be dominant. We call it credit risk. It's country sovereign risk, but it's the same concept. In that regard, and of course, the dollar denomination of the underlying securities makes them also relatively comparable in that regard.

Anu: Then maybe just from portfolio construction perspective, should folks be thinking of this as a strategic long-term allocation within their fixed income bucket, or tactically, this is something a shorter term play?

Gorky: We are advocates of a structural allocation for a couple of reasons. Historically, it has proven to have rewarded investors that have stayed the course. Of course, that means that you're going to have volatility, you're going to have periods of underperformance or outperformance, but it tends to be a bit of a mean-reverting universe. When you look at the longer cycles for the amount of volatility that generates, it does provide a fairly compelling total return.

If you start from a small allocation, structural allocation, but should be measurable, so it does have an impact in the broader portfolio, and then it's easier to tactically move around structural allocation. The conditions deteriorate or improve, or the market becomes more attractive from a valuation perspective, or it's becoming less attractive because spreads or yields have compressed, for example. Then you can tone down that exposure relative to a structural strategic allocation, not unlike any other assets, in fixed income or otherwise, equities or privates, for example.

Anu: A structural allocation and then make your more cyclical tilts based on macroeconomic conditions as needed.

Gorky: Exactly.

Anu: Now, folks are interested in emerging market debt. They might choose to implement that exposure through a passive ETF for their exposure, but tell us about the advantage of really using active management in this space. What's the case for active management versus a passive allocation for EMD?

Gorky: I have to speak my book, but of course I'll also be speaking the industry's book.

Anu: Please, yes.

Gorky: In the case of emerging markets debt, there is, again, a case for active allocation when we look at the performance over a cycle. If you pick top managers in the industry, you will see that they fairly consistently outperform the benchmark. Even because of costs embedded in execution and implementation, the passives will have a slight underperformance to the benchmark. Pretty much structurally, you will get slightly lower returns than those in the benchmark.

The active approach in a universe that remains still under-researched, under-covered, probably under-owned, essentially means that there are a lot of opportunity for alpha creation, but also because you want to be able to diversify, you don't want to be bound by benchmarks. There are a number of countries, for example, that are not represented in the benchmark. Corporate credit, which is also hard currency, denominated in our case.

We actively invest in corporate credits in countries that we like, but where spreads might be tight or not attractive enough, but if we believe the fundamental underlying story of a certain country is improving or positive, we're going to look for corporate credit opportunities where our corporate team has high conviction. Essentially, you avoid some of the pitfalls that come with indexing or index investment. Diversification is very, very important, and you, of course, can be proactive in terms of some of these events that we talked briefly, for example, the case of Argentina, where these types of events are pretty regular and very idiosyncratic and part of what drives EM risk and performance.

Anu: Absolutely. Now, rounding up the questions today, Gorky, if listeners do want to consider allocating to hard currency EMD, tell us a little about what they should really be thinking about in terms of risk management practices.

Gorky: I'm going to hone in again on diversification. You want to have a platform where the research capability is strong. We're, again, looking at a set of 70-plus countries across multiple regions, multiple time zones, very complex universe where the bottom-up country-specific research capabilities are very, very important. It's paramount to investment. Risk management, sizing oppositions, liquidity management, also should play a role in terms of how you invest in the asset class. Those are really the key areas that should be relevant when it comes to thinking about how to allocate into the EMD space.

Anu: Lovely. Thank you very much, Gorky. Those are my prepared questions for today, but I can't let you go without a very quick bonus question. As I understand it, you've covered emerging markets for many years, so I imagine you have visited lots of places around the world for work and maybe also for vacation. I'd love for you to tell us about a place or a trip that really stands out in your many years of traveling all over the globe.

Gorky: That's a very tough one. [laughs] There are so many to pick one. I would probably come down to two, and it's going to be either between Italy and Spain. Those are destinations where you cannot really go wrong in terms of the architecture, landscape, culture, food. I tend to gravitate into those. It's very tough. It's like asking what's your favorite food, almost.

Anu: [laughs] No, exactly. You certainly cannot go wrong with Italy or Spain.

Gorky: No.

Anu: Thank you so much for sharing that. Today, Gorky helped us demystify hard currency emerging market debt. We talked about what it is, how it differs from local currency, and why a softer dollar and an easing Fed cycle could be a tailwind. When we're talking about active security selection, Gorky highlighted this is an asset class that is under-research, under-owned, and that leads to really exciting alpha opportunities. He also talked about where hard currency EMD can fit between US investment grade and high yield as a complementary source of yield and diversification.

Finally, we talked about how research capabilities, liquidity management, and robust risk controls are so critical in allocating to emerging market debt. Gorky, thank you so much again for all these insights, and we hope to have you on the show again soon.

Gorky: Thank you.

Anu: To our listeners, we encourage you to subscribe wherever you listen to your podcasts, or you can go to our website at www.nb.com/disruptiveforces, where you can find our recent episodes as well as more information about our firm and offerings.

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