Investors worried about rising uncertainty may consider an allocation to short-duration credit, argues Tatjana Greil-Castro. There are things we cannot know, no matter how much data we crunch or how many reports we read. Accepting what is unknowable allows us to focus on aspects we can quantify and base decisions on.
This is especially true of investing. In theory, valuations should reflect a reasonable level of confidence about the upside and downside risk of an investment. Or, to put it another way, how much uncertainty will you accept to make a new investment or stay invested?
How tolerant are you?
Investors in equities or cryptocurrencies need a higher tolerance for uncertainty. While it easy to get caught up in the excitement of a bull run in a stock or sector, it is important to remember things can turn in a heartbeat.
After 2 years of 20%+ returns in US equities, recent developments in the US artificial intelligence sector highlight stock prices can move sharply in both directions. Reports that a previously unknown Chinese startup DeepSeek had built a large language model at a fraction of the cost of US competitors has raised concerns about AI hype and one company in particular. On January 27, Nvidia shares plunged 16.97%, wiping out almost US$600 billion of its value, the biggest single day fall ever for a US company.
Stock market downturns are often unexpected, happen rapidly, and take years to recover from. A relevant example for today’s tech-dominated US stock market was the bursting of the dotcom bubble in the early 2000s. After falling 75% between March 2000 and October 2002, it took the Nasdaq 15 years to fully recover.
Double jeopardy
Credit investors face uncertainty, too, much of which is coming from the new US administration. One moment, markets are trying to assess the impact of 25% additional tariffs on imports from Canada and Mexico; the next, we hear that tariff hikes are on pause for a month.
The long-term consequences of other shifts in US policy, including to immigration and deregulation, are equally difficult to quantify. Maybe they will prove positive for US growth and domestically focused businesses. But they could also be inflationary and significantly impact US interest rates and financial markets.
No-one knows how things will play out; however, unlike equities or crypto, credit investors can at least fall back on basic bond maths. We can calculate how much cushion exists in different parts of the credit curve before any increase in yields or spreads begins to negatively impact returns.
Announcements from Washington will cause volatility at various points, but they are unlikely to cause a wave of defaults to bonds issued by high-quality investment-grade and high-yield companies in the near term. Investors in bonds maturing over the next 1-3 years should, therefore, be confident they will continue to collect coupons and be repaid in full when the bonds mature.
Safety in numbers?
This is reflected in breakevens (a measure of how much yields or spreads would have to rise before returns become negative) across the credit curve. Rising bond yields over the past three years has led to a commensurate rise in breakevens across all parts of the US credit curve.
However, the level of cushion is considerably greater in the 1-3-year part of the curve – around 2.7% – and diminishes the further out you go. A similar narrative is playing out in the European and sterling markets.
There are no sure things in the investment universe. While there will be periods in which the stars align and there are opportunities to make hay, there are other times when greater uncertainty justifies a more pragmatic approach.
Investors with little tolerance for uncertainty and higher appetite for control may find what they are looking for in higher-quality, short-duration credit.
By Tatjana Greil-Castro, Portfolio Manager at Muzinich & Co.
