Emerging-Market Debt: Outlook, Insights, Level of Risk

Emerging-market debt is not a single, uniform asset class. It’s a diverse opportunity set with distinct risk and return drivers that can enhance a portfolio when understood correctly.  

The asset class can be a useful portfolio addition as it offers higher yields than developed-market debt. It’s also a growing category within fixed income and offers diversification benefits and exposure to some of the fastest growing economies in the world. 

Before deciding on the composition of emerging-market debt portfolio allocations, investors should carefully assess their appetite for credit risk, duration, currency risk, and country or regional exposures. 

The Emerging-Markets Debt Landscape report examines the categories of emerging-market debt, their structural differences, recent performance trends, and what investors should consider before allocating capital. For a complete look at these insights and the emerging-market debt landscape, download the full report.  

Emerging-market bonds are typically issued in US dollars or another G7 currency (usually the euro or pound sterling). The returns for these bonds are mainly driven by credit risk, with yields offering a premium over US Treasuries to compensate for issuer risk.  

When fundamentals are strong and there’s investor appetite for these bonds, yield spreads compress, while they widen when credit fundamentals and investor sentiment deteriorate. 

It’s therefore very important for emerging-market hard-currency sovereign bond managers to carefully assess a country’s macroeconomic fundamentals and creditworthiness.

As implied by the name, local-currency sovereign bonds are issued in the currency of the host country. Returns are primarily driven by domestic interest rate levels and currency movements. 

Currency performance is a function of economic competitiveness and demand, both from foreign investors and demand for a country’s exports.  

Over the long term, returns for emerging-market local-currency sovereign bonds have been mainly driven by income from coupons and, to a lesser extent, capital gains from yield compression over time, while currencies have mainly been a source of volatility and downside rather than returns. 

However, local-currency bonds can benefit from currency appreciation when the issuing countries attract investment flows because of improved competitiveness, strong economic growth, and rising productivity.

Corporate bonds are issued by corporations or quasi-sovereign companies, predominantly in hard currency such as US dollars. Similar to hard-currency sovereigns, returns are driven by credit risk and bottom-up analysis of corporate fundamentals. 

For emerging-market corporate bond managers, bottom-up analysis of corporate fundamentals is a key source of alpha. 

Managers can add value by taking advantage of market volatility, which can create attractive entry points, or by avoiding certain areas of the market that could face headwinds or are at risk of getting downgraded.  

In both sovereign and corporate bonds, investors are also exposed to default risk. 

The total emerging-market debt universe is approximately $9 trillion, representing about 11% of the global bond market. 

Local-currency bonds dominate the market with a cap of roughly $6.7 trillion, compared to $1.0 trillion each for hard-currency sovereign and corporate bonds, as of August 2025. One reason behind the growth and dominance of local-currency bonds is the preference of a number of countries to issue local-currency bonds as they are less vulnerable to foreign investor flows and have less currency risk.  

The hard-currency sovereign segment has not seen material growth in the past couple of years as large issuers, such as Brazil, China, and India, have been mainly issuing in local currency. 

The inclusion of China and India in local-currency indexes has been an important milestone. 

The hard-currency sovereign market is more diversified, covering around 50 countries, with larger exposures to the Middle East, Africa, and Latin America. 

On the other hand, the local-currency sovereign universe is more concentrated, covering 19 countries, with a much larger proportion represented by Asia.

Over the past 10 years, average default rates for hard-currency sovereign (1.9%) and corporate (1.3%) bonds have been lower than the U.S. high-yield market at 2.6%. 

Local-currency sovereigns generally have higher credit quality, with 81% rated investment-grade. While hard-currency sovereigns have a lower overall credit rating, with a mix of roughly two-thirds investment-grade and one-third high-yield. 

Local-currency sovereign bonds have a lower average duration, around 5.9 years,  compared to hard-currency sovereigns at 7.3 years. This makes local-currency debt generally less sensitive to interest rate volatility. 

Morningstar Indexes, often used as benchmarks in the fixed-income market, provide further insights into these trends.

In 2025, emerging-market corporate and local-currency sovereign funds have started to see inflows, though hard-currency funds continue to see outflows.  

Some managers believe foreign investors might start looking to diversify their international holdings away from the United States, which could be beneficial for emerging-market bond fund flows. However, we will need to see if the recent inflows into corporate and local-currency sovereigns will be sustainable. 

Following significant outflows in 2022, investor inflows are beginning to stabilize, and sentiment is showing signs of improvement.

During the 2022 selloff, local-currency and corporate bonds showed more resilience than hard-currency sovereign bonds, helped by their shorter duration and higher credit quality.  

Emerging-market debt stabilized in 2023 and recovered from 2022 losses, supported by proactive interest rate hikes by central banks, attractive yields, and better-than-expected economic growth.

Managers believe all-in yields remain attractive despite recent spread tightening, thanks to higher base interest rates and resilient fundamentals. However, it is important to assess risk factors, such as trade tariffs and geopolitical risks, before deciding on allocations. 

A selective, active approach is crucial as risks from inflation, trade tariffs, and geopolitics vary by country. On the corporate side, strong performance in recent years and spread tightening have increased the need to be highly selective, according to managers, because of rich valuation levels for the overall market.

Finding the right opportunities within the emerging-market debt landscape requires strategic decision-making and an understanding of client preferences. 

For higher credit quality, shorter duration, and currency exposure, advisors should consider the local-currency market. For yield enhancement, those with a greater appetite for credit risk and duration should look to the hard-currency universe. 

Overall, though, a blended approach can provide balanced, diversified exposure to this higher-beta segment of the fixed-income market. 

The emerging-market debt universe is diverse, offering compelling yields and diversification benefits.  

Success in tackling inflation, robust economic data, attractive real rates, and room for central banks to reduce rates have created a positive environment for emerging-market bonds and supported their strong recent performance. Trade tariff discussions have also led to a reallocation away from the US as investors seek diversification, with select emerging markets benefiting from that trend. 

Structural differences between hard-currency, local-currency, and corporate bonds create opportunities for managers to align their allocation with specific risk appetite and portfolio objectives. 

Review Morningstar's positively-rated hard-currency and local-currency funds by downloading the full report.