Debt divergence: Investors stand at the crossroads

Ben Lord, manager of the M&G Global Corporate Bond Strategy, points out that the most important thing to consider is not the level of debt itself but whether the country can afford it. For example, Lord highlights that in the US, 10-year Treasury yields (the interest demanded by investors to buy a government bond) are at 4.5%. Meanwhile inflation is between 2-2.5% and real GDP growth is above 2%, meaning current debt levels in the US are manageable. However, should GDP stop growing and inflation linger at 2%, investors would begin to grow more nervous about the affordability of the 10-year borrowing rate.
 

The sovereign debt road ahead

The supply of government debt is unlikely to diminish soon, with demographics, deglobalisation and decarbonisation likely to increase the burden on government spending. Lord highlights that “the Western world built these systems for baby boomers, baby boomers wanted them, and now the baby boomers are really starting to draw on these benefits.”

We can see this in the US, which has a large demand from its demographics, with social care and Medicaid – provided they aren’t drastically cut – likely to be an increasing cost in the coming years. The deficit for 2024 totalled $1.8 trillion and is predicted to rise to $1.9 trillion in 2025⁷. According to the Congressional Budget Office (CBO), since the Great Depression, deficits have exceeded this level only during and shortly after World War II, the GFC and the COVID pandemic. On a far longer-term basis, the CBO predicts public debt to reach 166% of GDP by 2054⁸.

The rise of populist politics has added more pressure on the debt burden. We saw this around the world in 2024 as more than 50 countries headed to the polls⁹, with parties across the political spectrum in the US, UK and elsewhere campaigning on expansionary, vote-winning fiscal policies. In the US, for example, both Republicans and Democrats campaigned on policies that would ultimately expand the deficit.

Where next for global sovereign debt?

It’s common to assume that the US, because of its exceptional position as the world’s reserve currency, can continue to increase its deficit without punishment from bond markets. However, there may be a point where investors say ‘enough is enough’.

“Debt definitely does matter, we just don’t know where that biting point is. We have to be closer to that point than we were two years ago simply by the fact that we have more debt,” Burrows notes. Investors are becoming more cognisant of the fact that even the most developed governments may run out of room for manoeuvre. As a result, “governments are becoming increasingly protectionist and capital is becoming a lot more flighty,” Burrows concludes.

According to Lord, once the bond market worries that an economy can’t afford the level of borrowing at the ongoing market rate, it will move aggressively and effectively. Then, it is a matter of finding a clearing level, where bond markets feel adequately compensated for the risks of buying government bonds. “In such an environment, I would be much more nervous about long-dated bonds than about shorter-dated ones,” he contemplates.

We have begun to see this: during the fourth quarter of 2024, estimates of the term premium edged up, indicating that investors demanded greater risk compensation for holding long-term US government debt. Meanwhile, Treasury auctions at the end of 2024 also underscore this concern, with some monthly auctions clearing at a higher yield than expected since 2022, reflecting investors’ unwillingness to absorb the ever-swelling supply of government debt¹⁰.

Andrew Chorlton, CIO for Fixed Income, highlights that “developed market governments have bonds to sell and if you have bonds to sell you have to find a buyer for them – it’s the basic rule of demand and supply.”

We have seen this increased nervousness and volatility demonstrated particularly in the UK. 

The UK has only recorded budget surpluses five times since 1970, with the most recent occurrence in 2000/2001¹¹. It also faces several challenges, including low economic growth and productivity, an aging population, high government debt and high borrowing costs¹².

Furthermore, real interest rates are currently higher than the real GDP growth rate, making it difficult to reduce the debt-to-GPD ratio without limiting public spending.

As a result, markets are alert to the sustainability of UK government debt. This was demonstrated during the 2022 Gilt crisis when the then-Chancellor Kwasi Kwarteng set out a range of tax cuts and a reduction in national insurance in the new government’s ‘mini-budget’. Later dubbed ‘Trussonomics’, the budget also included an increase in government spending in the form of an energy price cap. The implication of this decrease in revenue and simultaneous increase in spending was an expansion of the deficit. As a result, gilt yields spiked, rising from 3.5% to 4.3% as investors rushed to sell UK government debt¹³. “The market had reached its limit,” points out Chorlton.

According to Burrows, the 2022 Liz Truss episode demonstrated “how fleeting confidence can be.” He added, “once the bond vigilantes decide that they don’t want anything to do with a particular market, pricing can adjust quickly.”

There is “very little fiscal headroom” for the UK, Lord notes. As result, markets are alert to any perceived sense of fiscal profligacy. For example, markets wobbled following the most recent budget under the Labour government, which contained a tax grab from the private sector that could have negative consequences for growth. It is estimated that the budget is likely to push UK government bond issuance towards £300 billion¹⁴, further testing appetite. The bond market has already proven impatient, with 10-year gilt yields climbing to levels not seen since the 2008 financial crisis in January 2025¹⁵.

However, for Chorlton this may not be as damning as it sounds. In part, this phenomenon is due to the end of the quantitative easing (QE) programme that ran for over a decade after the GFC, where the Bank of England was a buyer of gilts, artificially suppressing prices. Now, “there are a lot of bonds for people to digest and the price has to correct. The credit quality of the UK government hasn’t changed dramatically in the last few months. It’s just that the price reflects a clean balance of risk and reward, without the distortion of QE,” the CIO outlines.

“You’ve got to persuade people to buy [UK government bonds] and that is the clearing price – it’s healthy but the government has to be very alert to it.”

Diverging paths in the debt landscape

The impact of government debt levels can acutely be seen in Europe where, because of the common currency and common central bank, there is a clear pricing of the credit risk of different countries. 

We can see this in the divergence between France and Greece. While France was formerly considered a stable economy, it is now hampered by a large debt pile, low growth and an uncooperative electorate. 

In fact, in November 2024, France’s government bonds (OATs) briefly yielded more than Greek government bonds¹⁶, often associated with its struggles during the eurozone debt crisis. 

Meanwhile, since its restructuring, Greece has been able to run primary budget surpluses, and was even able to repay some of its debts from a 2010 bailout programme because its upgrade to investment grade status has allowed more access to cheaper financing¹⁷. This demonstrates the importance of maintaining credibility and debt sustainability among investors. There exists a positive feedback loop where those countries with a sustainable debt level have better access to credit and are therefore better able to service their debt and invest in their country.

In turn, this has an impact on growth: between the eve of the COVID crisis in 2019 and 2024, GDP per head grew more than 11% in Greece, while France has grown less than 2% in the period¹⁸.

An alternative route for global debt

Given these dynamics, where can investors turn?

Burrows argues: “It’s a simple investment thesis that if economies are running into financial difficulties, you are better positioned elsewhere.”

Ultimately for Burrows, the increased flightiness of capital brings about investment opportunities to exploit. However, he is wary that change in the market can be “ruthless and brutal.” While we may not know the trigger, changes in dynamics such as political upheaval can spark “very swift and sharp changes in valuations.”

“All we can do is be alive to those risks as best we can and position one’s portfolio in places we deem as much safer and prevent any loss of capital,” he adds.

Lord agrees, arguing that in times of fiscal crisis, “the most important thing is to avoid them, and to have a fund that has the ability to invest in different parts of the world.”

Both Lord and Burrows are turning to countries with a more sustainable debt level, such as New Zealand. According to IMF data, New Zealand has a debt-to-GDP ratio of 48.6%¹⁹. Its government has committed to returning to a surplus and reducing its debt-to-GDP. 

The country underwent its own fiscal crisis in the 1980s with high inflation, soaring unemployment and mounting debts. However, it subsequently adjusted its fiscal rules to include a target stipulating that its net worth should remain at a level sufficient to act as a buffer to economic shocks and that total operating expenses in each financial year are less than total operating revenues in the same financial year²⁰. 

The fixed income fund managers highlight Australia, Norway and the United Arab Emirates as other countries with strong fundamentals compared to their developed market counterparts, which also have low debt-to-GDP ratios. 

What does this mean for corporate bonds?

Sovereign bonds and corporate bonds are intrinsically linked. Corporate bonds are made up of two components: the relevant underlying government bond yield and the credit spread (or risk premium) for lending to a company. Given the current dynamic within sovereign bond markets, how does this feed through into the corporate universe?

Considering the deteriorating fiscal situation for many developed markets, there may even be a point where investors decide that a high quality corporate is better than a sovereign bond, Chorlton argues.

Meanwhile, for Lord, there is a key consideration at play: if you have the choice between US Treasuries, which are rated AA+, being paid 4.5% or you get paid 30 bps more for Microsoft which is AAA rated, is there a case that Microsoft is a stronger credit than the US government? 

“In a fiscal crisis, you would have to say yes because Microsoft is not over borrowed or committing an unaffordable amount of benefits to their retired employees. It is taking in more money than it is spending, so you could argue it is a stronger credit,” he explains.

However, this tends to correct quickly, Lord notes. In the case of a fiscal crisis, the government is going to respond by cutting spending and increasing tax take from wherever they can get it, which would typically be the wealthiest companies or individuals. In this scenario, that would damage the growth prospects of the corporate bond while enhancing the case for the sovereign bonds – “this is less of a long-term fundamental trade as the government typically has room to act.”

Furthermore, while currently corporate bonds are trading at all time tights, there is a case that credit might be crowded out by government bonds. If there is such a supply of government bonds coming to the market and there is not enough pick up in yield to buy corporates, the spread (ie the difference between the government bond yield and the corporate bond yield) will become so compressed that investors may decide they are not adequately paid for the risk.
 

A detour through emerging markets 

Similar to the Western world, we have seen a dichotomy within emerging markets (EM) where fiscal reforms have been led by what were previously considered the most fragile economies. Meanwhile, several middle-income EM sovereigns have increased spending substantially. 

As Claudia Calich, Fund Manager, Emerging Market Debt, explains, EMs as a whole tend to have lower debt levels. However, because many of them borrow from international markets in hard currencies (an external currency typically seen as more stable, such as the dollar or euro), the threshold for market tolerance of debt levels is lower. Emerging markets would rarely be able to carry such high debt levels as developed markets do. Additionally, fiscal revenues, a key element for a sovereign’s ability to service debt, are normally lower in emerging markets given the structure of their economies and income levels.

Nevertheless, there are certain emerging market countries which are making substantial fiscal reforms and thus attracting more capital. “Those countries where fiscal adjustment is perceived to be tenable and long lasting, the markets absolutely would reward those countries,” Calich states.

Argentina is one of the most prominent examples of this. A country that has long been buffeted by financial woes before the election of President Javier Milei in 2023. The term ‘chainsaw economics’ entered the lexicon, coined following Milei’s bold action to turn around the Argentine economy – a result of his symbolic wielding of a chainsaw during the election campaign. Since coming to power, Milei has halted public works, slashed pension expenditures and public salaries, reduced energy and transport subsidies and axed more than 30,000 government jobs²¹.

As a result, Argentina achieved a fiscal surplus for the first time in over a decade. The country posted a surplus equivalent to 1.8% of GDP, and 0.3% after accounting for interest payments in 2024²². This was reflected in its bond market returns, with Argentina being one of the best performers in 2024.

Similarly, countries such as Egypt and Turkey which have undergone periods of economic uncertainty and are now targeting primary surpluses, with Egypt looking to have a primary surplus of 5% in the fiscal year ending June 2027, while Turkey is planning to achieve a surplus of 0.5% of GDP in 2025²³.

While these countries are looking to improve their fiscal position, others which have previously been considered to have more stable macroeconomic fundamentals, such as Brazil and Mexico, are adopting looser fiscal policies. Mexico’s fiscal deficit is expected to surge to 6% of gross domestic product in 2024, the highest in two decades. This is due to increased public spending on large infrastructure projects and growing current expenditures, according to the Official Monetary and Financial Institutions Forum thinktank²⁴. 

Meanwhile, Brazil is facing fiscal concerns with the Lula administration adopting a fiscal strategy of letting the deficit rise to accommodate higher social spending. The country saw higher interest rates of 13.25% in January 2025, which will likely contribute to an increasing debt-to-GDP ratio, reaching 85% by 2026, from 77.3% in 2024²⁵. 

This trend of diverging fiscal situations was also reflected in credit spreads (the difference in yield between EM bonds and US Treasuries) in 2024, where those of countries that are fragile but improving have narrowed disproportionately. As a result, the high yield segment of EM sovereigns outperformed in 2024²⁶.

Emerging markets as a whole not only tend to have lower debt ratios but they benefit from the policy anchor given in the form of the International Monetary Fund (IMF). Research from Morgan Stanley found that a total of 29 countries in the Emerging Market Bond Index Global Diversified, representing 27% of the index in weight terms, are in an IMF programme – the highest number since 2010²⁷.

As Calich notes, “countries with limited financing options often engage with an IMF programme that is designed to provide the country with short-term financing, providing breathing space and allowing the country to improve its fiscal framework, which is often the source of the problem.”

In emerging markets, as elsewhere, investors are reassessing the risk level of individual sovereigns as we have seen that from a fiscal perspective the road is diverging, with some sovereigns focusing on stability, while others face a deteriorating fiscal reality, which is likely to test bond market appetite. “There are always worries about EM debt. For emerging markets, it has always been a matter of analysing idiosyncratic country factors,” Calich highlights. 

We believe active managers are well placed to manage risk while also taking advantage of the opportunities such divergence offers as global debt levels continue to grow.