Navigating complexity in credit markets

Tight spreads throughout much of 2024 had reduced the margin for error. However, recent volatility has helped restore more attractive valuations in parts of the market. Against this backdrop, a reasonable investment approach remains rooted in identifying mispricings – opportunities where a security’s price does not fully reflect its fundamental credit risk. When that gap emerges, one acts. When it doesn’t, one waits.

Trade policy remains a key variable. Though we are still early in the current US administration, tariffs have already been announced, implemented, and in some cases, suspended. These developments have added a layer of unpredictability, further complicated by potential retaliations from the US’s main trading partners.

Tariffs are generally inflationary, but the magnitude and duration of that impact remain unclear. At the same time, while markets continue to price in interest rate cuts, central banks – particularly the US Federal Reserve (Fed) – may be constrained in responding proactively given the surrounding economic and policy uncertainty.

All of this, in our view, warrants a cautious investment stance. But caution does not mean inaction. This complex environment creates differentiated outcomes, even for similar companies. And when pricing disconnects from fundamentals, opportunities arise.

“When pricing disconnects from fundamentals, opportunities arise.”

Staying selective and strategic

Our portfolios entered the April volatility defensively positioned, with elevated allocations to liquid, low-volatility assets: T-Bills, short-dated government bonds, money market funds, and AAA-rated securitised credit. That positioning gave us the flexibility to selectively add corporate bond exposure as spreads widened and certain names we considered fundamentally sound were repriced more attractively.

We are value investors at our core. When the price of a security rallies towards or beyond its fair value, we trim exposure. If we do not find compelling alternatives, we hold cash-like assets and wait. We don’t chase marginal opportunities.

Within sectors, we continue to find value in financials, particularly the senior part of bank capital structures, which offer better downside protection for only a modest reduction in spread compared to subordinated debt. While real estate as a whole has become less appealing, we see selective potential in real estate investment trusts (REITs) with quality assets and sound strategic positioning.

Europe’s quiet appeal

Regionally, we currently favour European credit over its US counterpart. While both markets face headwinds, Europe offers a slightly more constructive macro backdrop. In the near term, tariff-related deflationary pressures and the prospect of fiscal stimulus, particularly from Germany, may provide support for European credit in an environment where the European Central Bank (ECB) still has room to ease.

In contrast, if the US pursues a path toward balanced trade, the corresponding decline in its capital account surplus could reduce demand for US financial assets over time. Combined with a more limited scope for monetary easing, this may act as a structural headwind for US credit.

Europe also stands out for another reason: diversification. Despite its scale, European credit remains under-represented in global portfolios. The region’s market is fragmented – one monetary policy governing multiple fiscal regimes and regulatory environments. This complexity, often seen as a drawback, creates inefficiencies that we believe skilled investors can exploit.

Flexibility and focus in a shifting landscape

One advantage of our approach is the breadth of our investable universe. We allocate across investment grade, high yield, and securitised credit while avoiding local currency emerging market debt and active currency or interest rate risk. The result is a credit-focused strategy that maintains an investment-grade profile and uses diversification as a key risk management tool, currently spanning more than 500 holdings.

That structural flexibility served us well in 2024. Financials and real estate were strong contributors as spreads compressed across rating bands. But we did not chase that rally. Instead, we used the strength to reduce risk, de-risking portfolios as spreads approached historically tight levels.

With some spread widening now returning, we are selectively adding exposure. Still, we remain cautious. In our view, spreads could move wider if trade tensions escalate or if new macro shocks emerge.

Looking ahead

The interplay of trade policy, inflation dynamics, and diverging monetary responses continues to shape an unusually complex credit landscape. But for value investors, complexity often translates into inefficiency – and inefficiency into opportunity.

By remaining focused on price and fundamentals, maintaining discipline through the cycle, and leveraging deep credit research, we aim to uncover value that others might overlook. In doing so, we seek to deliver risk-adjusted returns without taking undue interest rate or currency exposure – especially in a market where clarity may remain elusive.

* This article was first published, in Chinese, in the Hong Kong Economic Journal.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. The views expressed in this document should not be taken as a recommendation, advice or forecast. Past performance is not a guide to future performance.