Short duration EMD combines higher yields with protection against rising rates

Ridhima Sharma
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Short duration EMD combines higher yields with protection against rising rates

Emerging Markets Debt (EMD) continues to offer strong yield spreads to developed markets, while investing in shorter duration bonds guards against rising interest rates, suppresses volatility and presents beneficial reinvestment opportunities. As such, short duration EMD hard currency (HC) offers an option for investors seeking strong risk adjusted returns in their fixed income portfolios.

EMD offers investors an attractive premium versus developed market bonds; the EMD HC yield spread is 472 basis points to German 10-year bonds and 225 basis points to US Treasuries. Despite some recent volatility, emerging market fundamentals remain sound. External balances of many EMs have improved in recent years, current account deficits have been dramatically reduced and debt levels have declined. Regardless of some acceleration due to a pick-up in economic growth, inflation in emerging markets is fairly low. Real interest rates are still relatively high, providing higher risk premiums for investors as well as a buffer for local central banks against the need to hike interest rates.

Within the EMD HC universe, short duration presents further benefits, particularly in a rising interest rate environment. The first of these benefits is to reduce volatility. Movements in total return tend to be more subdued for shorter duration bonds than for the longer duration bonds issued by the same borrowers. For example, over the summer period of 2013, in May and June the EMBI Global Diversified index lost 8.87% while the 1-3 year sub-index only lost 1.41%. While the direction of the return is usually the same, the amplitude of the index-level fluctuations is less for the shorter-duration sub-indices. This lower volatility contributes to stronger risk-adjusted returns.

A second benefit of EM short duration bonds is the reinvestment opportunities that such a strategy affords. NN Investment Partners’ short duration product targets a duration of 1-3 years. In such a product, principal payments occur sooner, which, in an environment of rising US interest rates, facilitates reinvestment at higher rates.

Finally, short duration bonds offer greater credit roll-down returns compared to longer-dated bonds. As a bond approaches maturity, the probability of default or another credit event in the remaining outstanding period of the bond decreases, presenting a positively sloped credit curve. It is this positive slope that allows for roll-down return. However, this relationship is usually non-linear, with a steeper curve at short durations, as shown below in Brazil’s sovereign yield curve. A focus on shorter dated EM HC bonds therefore helps the strategy profit from strong roll-down returns that can be earned on this part of the yield curve.

Annemieke Coldeweijer, senior portfolio manager, Emerging Markets Debt at NN Investment Partners said: “We have a constructive view on emerging market hard currency bonds, based on a relatively benign global macroeconomic backdrop and economic indicators pointing to robust global growth dynamics. As the strengthening of economic conditions increases the risks of monetary tightening, short duration EMD provides an ideal way to mitigate the impact of potential rate rises, while providing an attractive premium and lower volatility.”

NN Investment Partners launched its NN (L) Emerging Markets Debt Short Duration fund in March 2018.The fund targets a duration of 1 to 3 years, enabling the fund to offer stable income and lower volatility.