Why Do Emerging-Market Bond Funds Keep Outperforming?

Key Takeaways

• Emerging-market bond funds are beating other US-dollar-denominated bond categories in 2025.
• Among the catalysts are the rising creditworthiness of emerging-market countries and increasing demand for diversification outside the US.
• The top-performing fund this year, SEI Institutional Investments Trust Emerging Market Debt, is up 13%.

Emerging-market bond funds are taking the lead in 2025, extending a run of strong gains over the last two years. Funds in the category have averaged an 8.2% return in the year to date, double the 4.3% average posted by intermediate core bond funds (the largest bond category).

Emerging-market bond funds hold US-dollar-denominated bonds from emerging-market countries. Most of these funds primarily hold government bonds, also called sovereign bonds, but emerging market corporate bonds are often found in their portfolios.

Among Morningstar’s 23 fixed-income categories, emerging-market bond funds are the top performer in 2025, except for local-currency emerging-market bond funds, which hold debt denominated in those countries’ currencies instead of US dollars. Local currency bonds have caught a tailwind this year, as the US Dollar Index is down nearly 10%. This increases the value of returns denominated in other currencies.

These funds’ performance this year marks a continued recovery for the category after its rough start to the decade. “After a once-in-a-century pandemic, a large-scale war directly involving two emerging-market sovereign issuers, and a repricing of US rates faster than any time since 1994, the asset class became priced for stellar future returns, and it is delivering,” explains Tina Vandersteel, portfolio manager of the $2.4 billion GMO Emerging Country Debt Fund GMOQX. The fund has a Silver Morningstar Medalist Rating.

Vandersteel’s fund has returned 12.3% this year, the third-highest return of the category. Out of the 47 funds in the category with more than $100 million in assets, only one is down this year, with all the others up more than 5%. The largest name in the category, the Bronze-rated $13.3 billion iShares JP Morgan USD Emerging Markets Bond ETF EMB, returned 8.2%.

Other top-performing emerging-market bond funds include the Neutral-rated $3.3 billion American Funds Emerging Markets Bond Fund REGGX, which has gained 11.6% this year, and the Neutral-rated $3.6 billion Eaton Vance Emerging Markets Debt Opportunities Fund EELDX, which has returned 9.7%.

Emerging-Market Bond Funds Make a Comeback

These funds’ ample returns stand in stark contrast to the depths they plumbed from 2020 to 2022. The category’s rebound has been strong enough that even longer-term returns are strengthening.

These funds have returned 2.3% over the past five years, ahead of intermediate core bonds’ 0.7% annualized decline. However, that’s behind the 4.7% annual return of US high-yield bond funds, which often vie for the same space in portfolios, as both sit on the high end of the risk/reward spectrum. Since they bottomed out in 2022, emerging-market bond funds have pulled ahead, returning 8.3% a year over the past three years. That compares with a return of 2.1% for intermediate core and 6.9% for US high yield.

A number of factors have combined to help boost the performance of emerging-market bonds in 2025. One is their low starting point three years ago. These bonds started out at rock-bottom prices after major underperformance in 2020 and outright losses in 2021 and 2022, when defaults spiraled, inflation rose and Federal Reserve interest rate hikes weighed negatively on bonds.

According to Vandersteel, there are normally only one or two defaults by emerging-market countries a year. However, amid the covid-19 pandemic, these funds were hit hard, as Lebanon, Argentina, Ecuador, Suriname, and Zambia all defaulted in 2020. For a time, the damage was cushioned by the drop in US interest rates as the Fed battled the pandemic-driven recession. However, this was followed by the Russian invasion of Ukraine in 2022, which further destabilized global markets. Sri Lanka, Ghana, Ukraine, Belarus, and Russia all defaulted that year. This time, the defaults were coupled with the Fed aggressively raising interest rates to fight inflation, which hit emerging market bonds hard. Returns from the category were down 14.1% in 2022.

Emerging-Market Reforms Boost Confidence

Against this backdrop, a number of emerging-market countries moved to implement reforms aimed at improving their creditworthiness. They raised rates higher and quicker than the Fed to head off inflation. Brad Godfrey, co-head of emerging markets at Eaton Vance, says the reforms have been crucial for bond funds’ success. “[By] quickly hiking rates when inflation is rising, [they] got control of inflation more quickly. You need stable prices to make long-term investments,” he explains.

Argentina, the site of the largest sovereign default in 2020, has undertaken radical reforms under President Javier Milei, who has slashed government spending and worked to build up foreign currency reserves. These changes have elevated unemployment and poverty but cut inflation substantially, causing bond prices to rise. Vandersteel believes emerging-market bonds are in a better place in terms of credit quality than they have in years.

US Volatility Drives Diversification

Finally, this year’s market volatility, amid trade wars and global uncertainty, has rattled markets and led investors to seek assets to diversify their portfolios outside the United States. “Investors are more concerned with risks in global markets, particularly around tariffs, trade, and the US federal deficit. [Since] those risks are by and large emanating from the US, it sparks the need to think about diversification,” says Pramol Dhawan, one of the portfolio managers of the Bronze-rated $2.2 billion PIMCO Emerging Markets Bond Fund PEBIX.

In 2022 and 2023, funds in the category saw a combined $13.1 billion of outflows, but the situation has been turning around. Investors have regained interest in the category, and as flows restarted in 2024, emerging-market bond funds brought in $2.1 billion that year and another $459.0 million in 2025. “People internalizing the need to diversify from the US is no small feat,” says Dhawan. “For the last decade and a half, clients have chased every flavor of US exposure.”

Emerging-market bonds provide an element of diversification even compared with other bonds, as their defaults typically don’t correlate with the US business cycle. Driven by factors unique to their countries of origin, they work separately from the usual US business cycle. As Vandersteel explains, “Emerging-market sovereign bonds typically have one or two defaults a year, whereas high-yield [US corporate] bond defaults follow the US business cycle.” She also cautions that while these bonds may not see a repeat of 2025’s performance in 2026 (because there isn’t that low 2022 base to start with), compared with US high-yield bonds, their yields are decent, considering their credit quality.