Key takeaways
- Emerging market debt is compelling as a medium‑term structural allocation, particularly for investors seeking to diversify away from concentrated U.S. exposures.
- Fundamentals and technicals in emerging markets have improved, with better inflation control, higher real rates, healthier external balances, and room for flows to return after years of outflows.
- Local‑currency emerging market debt looks especially interesting as an extended dollar‑strength cycle likely gives way to longer‑term dollar weakness.
Recent market volatility and the conflict in Iran have understandably pushed many emerging market investors to the sidelines. But periods of uncertainty have historically offered attractive entry points into emerging market debt (EMD), particularly when underlying fundamentals are improving and asset flows are likely to increase.
We view EMD as a structural allocation because the asset class has matured and broadened significantly over the past three decades. It is now a mainstream component of many institutional portfolios, supported by seasoned, sophisticated investors who actively differentiate between countries, sectors, and credits rather than treating “emerging markets” as a monolith.
Diversifying away from U.S. concentration
One of the most powerful arguments for EMD today is diversification away from an increasingly expensive United States. The U.S. has become a source of political and policy instability, with elevated risks on the fiscal, economic, and political fronts that are unlikely to dissipate quickly. At the same time, international investors are heavily concentrated in U.S. markets, especially U.S. equities and private assets, where valuations have expanded meaningfully.
These dynamics are prompting allocators to reassess overall portfolio risk, including hedging strategies and the sustainability of outsized U.S. exposures. We began to see this process play out last year, when EMD and other non‑U.S. asset classes outperformed U.S. markets as investors sought diversification. The latest bout of geopolitical risk may accelerate that shift, as investors look for ways to maintain income while reducing dependence on U.S. assets.
Diversification within emerging markets
Equally important is the diversification that EMD offers within emerging markets themselves. The opportunity set spans roughly 80 countries and three distinct sub‑asset classes, each with different risk and return drivers.
- Sovereign hard‑currency debt: U.S. dollar‑denominated government bonds from around 80 countries give investors access to EM credit without direct currency/FX risk.
- EM corporate debt: A market that has grown over the past decade to approximately the size of the U.S. high‑yield market, with about 60 countries and 700 issuers across a wide range of sectors, not just the traditional oil, gas, and financial names that once dominated EM corporates.
- Local‑currency debt: Bonds issued in domestic currencies across roughly 30 countries, offering both income and currency exposure.
Compared with emerging market equities, the debt universe is broader and less concentrated. For example, the MSCI Emerging Markets Equity Index covers about 24 countries and is heavily weighted toward Asia, with China and Taiwan each accounting for roughly 20 percent or more of the index and the top five countries representing about 75 percent of total weight. In contrast, EMD provides a wider array of countries, regions, and sectors, which can help smooth portfolio outcomes over time.
Fundamentals and technicals: a stronger starting point
To understand why we see opportunity in EMD today, it’s important to look back at recent history. In 2020, when COVID‑19 hit, many smaller EM countries were vulnerable, and some went through default and restructuring cycles. That period was followed by the inflationary shock associated with the Russia‑Ukraine war in 2022, which further strained many economies.
Over the last three years, however, we have been in a credit upswing, with more ratings upgrades than downgrades across emerging markets. A key reason is the proactive stance EM central banks took on inflation: many began raising interest rates ahead of the U.S. Federal Reserve, implementing pre‑emptive hikes to contain price pressures. This reflects years of capacity‑building, as more EM central banks have adopted formal inflation‑targeting frameworks and improved their ability to anchor inflation expectations.
Today, inflation has been brought down effectively in many markets. Most EM central banks are on hold, some still have room to cut, and we see little need for broad‑based additional tightening at this stage. Real interest rates are close to historical highs, a stark contrast with 2022, when real rates were negative in many countries. Meanwhile, growth has proven resilient, reserves have been rebuilt, and external balances—including current accounts—generally look healthier than they did a few years ago.
On the technical side, EMD endured one of its worst outflow cycles from 2022 to 2025, as investors reacted to the sharp global rate adjustment. Many allocators reduced or exited positions, leaving the asset class far from crowded. Although we began to see inflows return last year, the war in Iran temporarily stalled that momentum. With positioning still light and income generation very high, particularly in dollar‑denominated segments, we believe even modest reallocations into EMD could offer meaningful support for returns. Historically, income has driven most of the total return in hard‑currency EMD, making dislocations attractive opportunities for long‑term investors.
Local‑currency debt and the dollar cycle
A third pillar of the EMD opportunity set is local‑currency debt, which we see as particularly compelling in the context of the U.S. dollar cycle. Over the past decade, the dollar has been in a strong, extended uptrend; historically, these cycles tend to last seven to eight years, suggesting the current period of dollar strength is already long by past standards.
We began to see hints of dollar weakness last year, but on a long‑term chart, that move still looks like a small blip relative to the potential downside. At the same time, U.S. fiscal pressures remain elevated, and political and policy uncertainty continue to weigh on the long‑term dollar outlook. Combined with improving fundamentals in emerging markets, this argues for a weaker dollar versus EM currencies over the medium term.
There are also important technical drivers. As international institutions have increased their U.S. asset holdings, particularly in equities, many have not fully hedged that exposure. We are now seeing hedging ratios begin to shift, and even incremental changes in how institutional investors hedge and allocate away from dollar‑oriented assets can influence currency dynamics. In such an environment, local‑currency EMD can offer not only attractive yields but also the potential for currency appreciation against a weakening dollar.
A mature and strategic asset class
Emerging market debt has now existed as an investable asset class for more than 30 years. Over that time, it has grown into a broad, deep market that spans sovereigns and corporates, hard‑currency and local‑currency debt, and a wide range of regions and sectors. The investor base is predominantly institutional and sophisticated, capable of distinguishing among countries and issuers rather than treating all EM exposure as a single risk bucket.
Importantly, shocks do not affect all emerging markets equally. For example, a conflict that drives energy prices higher will tend to benefit oil exporters while creating headwinds for more vulnerable oil‑importing economies. This dispersion creates room for active managers to seek out relative winners and avoid the most fragile credits.
In our view, today’s combination of improved fundamentals, constructive technicals, and a potentially weaker dollar backdrop makes this an opportune moment for investors to reassess their emerging market debt allocations. For those willing to look beyond headlines and embrace a diversified, medium‑term approach, EMD can play a meaningful role in building resilient, income‑generating portfolios.
This material may not be reproduced or distributed without Payden & Rygel’s written permission. This presentation is for illustrative purposes only and does not constitute investment advice or an offer to sell or buy any security. The statements and opinions herein are current as of the date of this document and are subject to change without notice. Past performance is no guarantee of future results.
This material has been approved by Payden & Rygel Global Limited, a company authorised and regulated by the Financial Conduct Authority of the United Kingdom, and by Payden Global SIM S.p.A., an investment firm authorised and regulated by Italy’s CONSOB.
A message from Advisor Perspectives and VettaFi: Discover something new! Click here to register for our upcoming webcasts.
© Payden & Rygel
Read more commentaries by Payden & Rygel
