Emerging market bonds are booming, with the spread against U.S. Treasuries approaching the 2007 low!

As the appeal of traditional safe-haven asset U.S. Treasuries declines, investors are flocking to emerging market bonds, pushing the spread of high-rated emerging market government and corporate bonds relative to U.S. Treasuries down to its lowest level since the financial crisis.

Latest data shows that the premium of investment-grade emerging market sovereign bonds over U.S. Treasuries has fallen to 1.04 percentage points, while the premium for corporate bonds stands at 1.1 percentage points. This marks the tightest sovereign bond spread since 2007, while the corporate bond spread is also nearing the low point before Trump's election.

This trend indicates that investors' concerns about the potential impact of Trump's erratic trade wars on emerging markets have diminished, shifting their focus to the gradually improving economic conditions in these countries. At the same time, Trump's criticism of Powell and the rising levels of U.S. government debt have made investors cautious about U.S. Treasuries.

"Traditional safe assets are not as safe as they used to be, which is one of the factors driving people into the credit market (including emerging markets)," said David Hauner, head of global emerging market fixed income strategy at Bank of America. He also noted that the "super strong" global stock market and a weakening dollar have provided additional support.

The overall spread of the JPMorgan Emerging Market Bond Index (including investment-grade and high-yield) has narrowed from 3.9 percentage points in April this year to just above 3 percentage points, reaching its lowest level since early 2020. Emerging market sovereign bonds and corporate bonds offer yields of 7.3% and 6.3%, respectively, compared to a 4.3% yield on 10-year U.S. Treasuries.

Increase in High-Rated Issuers Boosts Bond Market Expansion

The market has been buoyed by high-rated Gulf countries becoming regular issuers of bonds.

For example, Saudi Arabia is expected to be one of the largest issuers of emerging market debt for the second consecutive year, as the country is utilizing the debt market to navigate the downturn in oil prices and fund its "mega projects."

"The emerging market investment-grade spread is indeed tight relative to historical levels. However, the credit rating quality in this space has also significantly improved in recent years," said Shamaila Khan, head of emerging market fixed income at UBS Asset Management.

Global Investors Accelerate Positioning

The tightening spreads also reflect the "convergence trade" happening between high-quality credit in emerging markets and developed markets. Aaron Grehan, co-head of emerging market debt at Aviva Investors, pointed out, "Over the past two to three years, we have seen global investors increasingly participate in emerging markets (especially investment-grade)."

Hauner added, "Emerging markets have been severely underweight for years. If people hold less, they have more room to continue increasing their risk exposure in emerging market credit."

However, some analysts believe that the optimism among investors leaves little room for a sharp decline in global economic growth expectations or the potential risks of inflation driven by U.S. tariffs.

Jonny Goulden, head of emerging market fixed income strategy at JPMorgan, stated that while U.S. economic data may be better than expected, "if recession risks remain low, there isn't much room for spreads to tighten further," but "if recession risks re-emerge, spreads could significantly widen."