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*