Why EM short duration bonds?
Carefully selected EM short duration bonds offer the benefit of attractive yields compared to developed market counterparts, with lower volatility than broad duration bonds.
The “pull-to-par” effect can lower portfolio volatility
Bond prices reflect credit default risk and macro risk. The closer a bond moves to its maturity date, the more the bond price will start reflecting just the credit default risk. Essentially, this means that if the company doesn’t default, bonds pay back “par” (the face value paid for the bond) irrespective of what happens to the US Treasury rate and other macro factors. This significantly reduces the volatility compared to a longer maturity bond where the price is affected much more by changing US Treasury rates and other macro factors.
For example, based on historical volatility over the last 10 years, we have calculated that the volatility of a 10-year bond is 4x higher1 than a bond with a maturity of 3 years. By being invested in shorter duration bonds and holding them to maturity, one can “lock in” the yield-to-maturity and mitigate the volatility risk. However, this strategy only works with an active management style as it requires accurate credit analysis.
Valuations are attractive in the front-end of the curve
There are currently about $12.5 trillion of negative yielding bonds globally, reflecting the souring outlook on global growth. Against this more cautious backdrop, EM short duration bonds offer higher spreads to developed market equivalents with limited volatility, making them an attractive cash proxy.
Additionally, our analysis of the whole EM hard-currency universe (over 3,500 bonds between sovereigns and corporates) highlights that the yield benefit of extending maturity or duration is minimal given that the yield curve is relatively flat (see following chart). This means that a short-duration focused strategy has the potential to deliver attractive risk-adjusted returns.
Average yield for BBB dollar sovereigns and corporates (%)
Agility in asset allocation is crucial to boosting risk-adjusted returns
Taking advantage of the flat yield curve requires the flexibility to manage bonds across the emerging market debt universe (be they corporates or sovereign) as well as across the credit spectrum. Risk-return logics tells us that in “normal” market conditions corporate bonds should pay a premium to the sovereign bond. This is simply because a corporate bond has additional credit risk versus its sovereign. However, this is not always the case. Because of market dislocations, corporate bonds might trade in line with their sovereigns or indeed pay less than the sovereign. As such, the ability to invest in both is paramount in order to maximise risk-return.
Corporates typically tend to offer a higher yield than the sovereigns. To take an example from our strategy, the Russian gas giant Gazprom currently offers bonds with about 50 basis points of higher yield than Russian sovereign bonds, both maturing in about 3 years’ time. As we think that neither the Russia sovereign nor Gazprom will default, and Gazprom’s rating is one notch higher than the sovereign, locking in that extra 50 basis points of yield-to-maturity increases return potential without additional volatility.
However, there are some exceptions where being invested in sovereigns over corporates make more sense. For example, there are certain sovereigns like Egypt where there are no suitable corporates with a similar risk profile to the sovereign. Likewise, there are corporates in Ukraine like MHP (a poultry producer) where the bonds trade about 80 basis points tighter to the sovereign. Even though we think MHP is a strong credit, in this case we believe it makes more sense to be invested in the sovereign to lock in the higher yield-to-maturity.
Concerns over the end of the economic cycle favour EM short duration bonds
Global data suggests that we are likely late in the economic cycle. While this might be the case, it is impossible to predict exactly when the cycle will end. However, a pickup in volatility is characteristic of late cycle market dynamics. Hence, it is prudent to look for defensive ways to participate in the financial markets. EM short duration bonds can be an attractive asset class as it offers low volatility while providing higher carry potential compared with developed market counterparts. In 2018, when volatility picked up and 89% of all asset classes posted negative returns, Jupiter’s global emerging markets short duration bond strategy was flat. Yet the strategy was also able to participate in this year’s market rally. In short, an EM short duration bonds approach can offer both return potential during bullish markets, along with the benefit of limiting volatility when markets are risk-off.
1 Based on US Treasury data from 2011 to May 2019.
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