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The comeback in emerging markets debt has refocused attention on the asset class during 2016. But what if you have a constrained risk budget, or a nervous eye on the U.S. Federal Reserve and tightening global monetary conditions? A short-duration approach may be the answer.

A year ago investors couldn’t get away from emerging markets fast enough. But that all changed in the spring of 2016, as the emerging world set off on a significant and ongoing rally. By the end of the third quarter the MSCI Emerging Markets Index of equities was up 16%, the JP Morgan EMBI Global Diversified Index comprised of hard-currency bonds was up 15% and the JP Morgan GBI-EM Global Diversified Index measuring local-currency bonds was up a storming 17%. Underlying those moves we see the growth slowdown in some major commodity-exporting economies bottoming-out, creating a widening growth differential with the developed world. It’s no wonder that many are now looking to add to their emerging markets debt exposure.

Those hesitating are generally doing so for one of three reasons: a lack of risk budget to spend on a volatile asset class such as emerging markets debt; a suspicion that the rally may already be a little stretched; and concern about the exposure of hard-currency debt, in particular, to rising U.S. interest rates and tightening global monetary conditions.

If you are one of these hesitant investors, we suggest that a short-duration exposure to the asset class, with a focus on hard currency-denominated instruments, may be the solution.

Less Interest-Rate Exposure, Less Volatility

For those who are not constrained by their risk budget and are confident in the bullish case for emerging markets, on fundamental grounds and looking through potential rate rises, the wider all-maturities universe, including local-currency markets, is still the one to go for: it will deliver fuller exposure to any price appreciation still to come, and it clearly provides the broadest opportunity set.

A short-duration exposure, however, offers hard-currency emerging markets debt with less sensitivity to rising rates, lower volatility (because the larger part of returns tends to come from coupon payments rather than price appreciation) and, as figure 1 shows, generally lower drawdowns.

Figure 1: Short Duration Emerging Markets Debt has Experienced Lower Drawdowns than other EMD Sectors Performance of Four EMD Sectors During the Top-Five Drawdowns in the Hard-Currency Debt Market, 2003-2016

Source: Bloomberg. The chart shows the top-five drawdowns in the JPMorgan EMBI Global Diversified Index (“EMD Hard Currency”). EMD Corporates is represented by the JPMorgan CEMBI Diversified Index; EMD Local Currency is represented by the JPMorgan GBI-EM Global Diversified Index; Short Duration EMD is represented by an equally-weighted blend of the JPMorgan EMBI Global Diversified 1-3 Year Index and the JPMorgan CEMBI Broad 1-3 Year Index.

A Growing Opportunity Set to Choose From

What are the trade-offs for lower volatility and less interest rate exposure?

Most obviously, investors would be opting for a smaller universe of bonds. But it is probably a bigger universe than you imagine, and one that has grown substantially over recent years due to substantial issuance from the corporate sector, in particular.

While there is no universally-accepted definition of “short duration”, we consider bonds with a duration shorter than five years to be in scope (although we would advocate targeting an average duration close to two years in a portfolio). Screening the benchmark sovereign and corporate indices for bonds with a maximum of five years’ duration, as we do in figure 2, leaves a universe of around 100 sovereign and quasi-sovereign issuers, 450 corporate issuers, and more than $800bn worth of bonds to choose from.

Overall, we believe that the current universe of short-duration hard-currency bonds is broad and deep enough to build a portfolio that is well-diversified across countries, sectors and issuers.

Figure 2: The Short Duration EMD Universe has Grown Substantially

Market Capitalisation, $BN

Number of Issuers

Source: JPMorgan, Neuberger Berman. The charts show bonds and issuers of bonds with less than five years’ duration from the JPMorgan EMBI Global Index and the JPMorgan CEMBI Broad Index.

A Compelling Risk-Return Trade-Off

Usually, investors have to give up some expected return in exchange for less expected risk, and it is no different with short-duration bond exposure. But again, the trade-off is probably more favourable than you’d imagine.

Because there is no standard short-duration emerging markets debt benchmark that encompasses both sovereign and corporate issuers, we created a proxy by equally-weighting a combination of the JPMorgan EMBI Global Diversified 1-3 Year Index and the JPMorgan CEMBI Broad 1-3 Year Index, which gives us an average duration close to two years.

As figure 3 shows, relative to the wider, all-maturities hard-currency emerging markets debt universe, the short-duration exposure slashes interest rate sensitivity down from the average of six years in hard-currency sovereign and corporate debt, and in doing so gives up less than two percentage points of yield—as the credit curve is currently relatively flat.

However, figure 3 also looks at the long-term relationship between return and risk and shows short-duration delivering two-thirds of the return of the all-maturities hard-currency debt index with only half the volatility. Indeed, the Sharpe ratio of short-duration emerging markets debt has been the highest of the different asset classes shown in figure 3 over the period since 2003.

Figure 3: Cut Back on Duration and Volatility while Preserving some Yield and Return Expectations

Current Yield versus Current Duration in Years

Risk-Return, 2003-2016

Sharpe Ratios, 2003-2016

Source: JPMorgan, Neuberger Berman. For short-duration hard currency emerging markets debt (HC SD) the charts show an equally-weighted combination of the JPMorgan EMBI Global Diversified 1-3 Year Index and the JPMorgan CEMBI Broad 1-3 Year Index. EMD HC is represented by the JPMorgan EMBI Global Diversified Index; EM Corporates by the JPMorgan CEMBI Diversified Index; EMD LC by the JPMorgan GBI-EM Global Diversified Index; U.S. Corp HY by the Barclays U.S. Corporate High Yield TR Index (USD Unhedged); U.S. Corp IG by the Barclays U.S. Agg Corporate TR Index (USD Unhedged); UST by the Barclays U.S. Agg Treasury TR Index (USD Unhedged).

Why Active Management for Short Duration EMD?

In debt markets there is more to risk than volatility and interest rate sensitivity, of course. Default risk and distress situations can have a severe impact in a portfolio of short-maturity bonds for two reasons: when there are fewer coupon payments to be made overall, missing some has an outsized impact on total return; and issuers in distress have less time to recover their ability to pay coupons and, especially, principal at maturity.

At the same time, the lower expected total return from a short-maturity bond means that portfolio trading costs will eat away a larger portion of an investor’s returns. Ideally, a short-duration bond portfolio manager would buy and hold every position, paying the bid-offer spread once and once only. A passive strategy would be forced to trade based on changes to index composition, or to sell bonds when their maturities come to within the one-year threshold that index rules typically dictate as ineligible for inclusion.

An investment approach focusing on fundamental credit research and modest portfolio turnover is desirable for short duration emerging market debt, as it can both limit exposure to potential default and distress situations, and help limit the number of positions that have to be sold out of a portfolio before maturity.

To sum up, if you are one of the many investors who are encouraged by the comeback going on in emerging markets debt at the moment, and you have the risk budget to spare, the wider, all-maturity solution in emerging markets debt, whether hard- or local-currency, should suit your needs well. If you are constrained by a strategic risk budget, however, if you want to express a tactical view on rising interest rates in your hard-currency emerging markets debt allocation, or if you simply want to be able to calibrate the volatility and interest rate sensitivity of your overall emerging markets debt exposure, the addition of a short-duration strategy may be the solution—as long as you embrace active management and select a competent provider.

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