Investors cannot ignore the wealth of investment opportunities offered by the emerging market debt (EMD) asset class. In a world of ultra-low or negative rates, investors have to look outside of developed markets in the ‘hunt for yield’. There is still around $16tn worth of negative yielding debt globally, and just 9% of global fixed income markets offer investors yields of over 3%1 – with unprecedented levels of coordinated monetary stimulus on a global scale, this is unlikely to change dramatically any time soon.

The EMD asset class not only offers huge diversification, encompassing around 100 countries at varying stages of their economic cycles, but it also provides access to high economic growth, with around 70% of global growth coming from emerging markets. With a growing investor base, EMD has been one of the fastest-growing fixed income sectors over the past decade, expanding into a widely diversified $23tn market, which is the same size as around 50% of all developed market government and corporate debt combined.

While the opportunities offered by EMD are evident, risk appetite towards emerging markets does still tend to swing dramatically, from periods of indiscriminate buying when sentiment is strong, irrespective of credit fundamentals, to selling ‘at any price’ when conditions are looking tough. But a more challenging macro backdrop doesn’t mean that investors should shy away from the asset class. Instead, an EM short duration bond approach can provide more cautious investors with exposure to the yield premium offered by EMD, while also limiting the impact of macro volatility.
The benefits of short duration
Carefully selected short duration emerging market bonds offer the benefit of attractive yields compared to developed market counterparts, but with lower volatility than broad duration bonds. This is because short duration bonds benefit from the ‘pull-to-par’ effect: as a bond gets closer to its maturity date, its price will begin to reflect only its credit default risk. If the bond doesn’t default, it will pay back its face value, irrespective or what happens to the US Treasury rate and other macro factors. This makes short duration bond strategies much less volatile than those with a broad duration.

In fact, the volatility of a 10-year bond is as much as 9x higher than that of a bond with a maturity of 3 years.2 By being invested in shorter duration bonds and holding them to maturity, investors can therefore “lock in” the yield-to-maturity while significantly reducing the volatility risk.

Exposure to EM short duration bonds can be beneficial across all market conditions, allowing investors to benefit from rallies when markets are more buoyant, while limiting downside risk in tougher times. Nevertheless, in order to achieve attractive risk-adjusted returns, we believe it is prudent to take an active, flexible investment approach, as accurate credit analysis is required to identify the names with the strongest fundamentals, which are trading at attractive valuations.

Short duration bond funds can be used as a ‘cash proxy’, as returns are highly likely to be positive with low volatility on a three-year rolling basis. As a significant portion of a short duration fund matures on a rolling three-year term, the high yield materialises into positive returns, independent of market conditions. Due to the high yield offered by emerging market debt, the realised return for EM short duration bonds is also likely to be much higher than developed markets bonds in US dollars.
Our approach at Jupiter
We launched the Jupiter Global Emerging Markets Short Duration Bond fund in September 2017, with an objective to provide attractive returns but with limited levels of volatility. We are pleased with how our investment approach has worked so far: since its launch, the fund has returned 13.8%, with the highest Sharpe ratio (return/volatility) in its peer group since inception.3

The last three years has been a highly volatile period, with the market selling off sharply in 2018, as well as the Covid-19 pandemic this year. Despite the volatile market backdrop, however, the fund managed to generate strong positive returns. Several characteristics have helped the fund to generate this strong performance, with limited drawdowns.

Flexibility to invest across the EMD spectrum: The fund has the flexibility to invest in sovereign and corporate, hard and local currency, and investment grade and high yield bonds. We believe an agile, fundamentals-focused approach is vital, allowing us to respond as the facts change, and take advantage of opportunities as they arise.

Limited volatility – duration and credit risk: By design, the fund limits duration and credit risk, both of which are major sources of volatility. The fund’s average effective duration will not exceed three years, and we never use derivatives to manage duration – the fund’s duration is simply the average duration across all bonds held in the portfolio. In terms of credit risk, while we can invest in lower-rated bonds, the fund’s average credit rating will not fall below BB.

Active management with in-depth fundamental analysis: We conduct in-depth fundamental analysis before investing and continue to monitor developments in newsflow or changes in fundamentals. Our active and flexible investment approach means we can respond as the facts change and reposition the fund accordingly. Security differentiation and country differentiation remain important to us, particularly given the current market conditions, and we continue to closely monitor global macro developments.

CDS and currency hedging: We have the ability to add protection effectively through credit default swaps (CDS) and hedges against local EM FX.
How do we compare to our peers?
The EM short duration bond fund universe is very small – there are no more than 15 funds with EM short duration mandates (with similar characteristics to the fund). Even within that small universe, there are still significant disparities – some funds focus solely on corporate or sovereign bonds; some can only invest in hard currency; some are restricted to investment grade names; and others have an average duration of more than 5 years.

The team’s defensive approach and focus on limiting downside has helped to limit what could have been much larger drawdowns, and it has put the fund in a strong position relative to many of its peers.

Risk/Return since inception*

Past performance is no indication of current or future performance, doesn’t take into account commissions and costs incurred on the issue/redemption of shares.
Source: Jupiter, as at 31.08.20, NAV to NAV, gross income reinvested, net of fees. Fund Inception 05.09.17 *(data run from 01.10.17). Performance is Jupiter Global Emerging Markets Short Duration Bond Fund I USD Acc. Performance shown against a custom peer group made up of EM short duration bond funds only within the Morningstar EAA OE Global Emerging Markets Bond.**Source: Jupiter, as at 31.08.20. shown from 02.01.19 to 01.05.20.

Challenges faced over the past three years
We take a defensive approach to investing, conducting careful analysis on countries and individual credits with a focus on valuations and limiting drawdowns. Over the past three years, there are many examples that demonstrate our ability to participate in market rallies, while effectively managing drawdowns.

2018 – When volatility picked up and 89% of all asset classes posted negative returns, Jupiter’s EMD short duration strategy outperformed most of its peers, with a slightly positive return for the fund for the full year. There were two primary reasons for this performance. First, the fund was well diversified, so even though the market fell as a whole, the fund had exposure to areas to the significant segments of the market that nevertheless performed well, which aided the fund’s overall performance. Second, one of the primary reasons for the volatility in the market’s returns in 2018 came from duration risk. Since the fund was by mandate-limited in duration, its volatility was lower relative to other asset classes.

2019 – Politics has been one of the key sources of volatility in recent years across Latin America. The three largest markets in the region – Brazil, Mexico, and Argentina – saw a shift towards more populist governments, while we also saw protests in countries such as Colombia and Chile.

However, the increased volatility in the region provided us with many opportunities to add to the portfolio corporate credits with solid fundamentals that were trading at cheap valuations. For instance, we saw value in solid exporters in Brazil and Mexico, which make sales in US dollars and which benefited from a depreciation of the currency. We also took advantage of the volatility by adding integrated energy companies that enjoy government support, but which trade widely to their respective sovereign debt.

Through our bottom-up approach, we were able to separate the noise from the credit fundamentals and thus generate alpha for our investors. Broadly speaking, across the regions in which we invest, we actively seek to mitigate political risk through careful selection of strong corporate names, or at times, through CDS protection too. This helps to reduce the fund’s volatility.

2020 – As the Covid-19 pandemic resulted in lockdowns across the globe, markets faced their largest shock since the Global Financial Crisis. We applied three key strategies to the fund in light of the market-wide selloff we saw in March. First, we tried to avoid major pitfalls by going through the portfolio with a fine-tooth comb to identify what we believed were the most vulnerable names. Each position had to be reassessed against the backdrop of the pandemic and the resulting drop in economic growth. For some businesses, the impact was minimum, while others (e.g. travel, shopping malls) felt a significant impact.

We were quick to identify and reduce our exposure to such names where we considered the businesses did not have a sufficient cash cushion to weather the shock. Second, we started to buy bonds that got caught in the indiscriminate market sell-off, but which had strong fundamentals. Finally, we maintained our disciplined approach and did not panic alongside markets, holding onto many names with strong fundamentals that we believed should not only survive the crisis but could come o