In response, the yield curve has steepened aggressively. Ten- and 30-year German bund yields have surged (prices fallen). Meanwhile, two-year bund yields are also higher, underperforming two-year US Treasuries but behaving better than longer maturities. Our rates team believes that further underperformance relative to US Treasuries is likely.

Credit spreads have moved in the opposite direction. US spreads are widening, up to 10 basis points month-to-date, while European spreads are tightening. This reflects weaker US growth expectations, as headlines on tariffs and looming government job cuts weigh on sentiment, and potentially stronger European growth. Some investors are seizing the opportunity to add European credit at yields higher than a few weeks ago, confirming strong overall demand for corporate bonds due to the attractive yields on offer.

What happens next?

We expect the longer end of rates curves to remain noisy. However, amid all this volatility, it's reassuring that the shorter end of curves remains relatively stable. Given the current backdrop, we anticipate an increase in credit spread volatility from a very low level. However, any widening should be relatively well contained due to the attractive overall yields.

There is a major caveat: if the US enters a recession this year, all risk assets, including credit, will suffer further. This, though, isn't our current base case.

Divergent central bank policy

Coming into 2025, we expected divergence between US and European central bank policies, further fuelled by the Trump 2.0 administration. After cutting rates three times since September last year, the US Federal Reserve has indicated it will temper further cuts until it can gauge the impact of Trump’s policies on growth and inflation. The latest uptick in Consumer Price Index inflation to 3% for the first time since June 2024 was an unwelcome surprise.

The Bank of England and the European Central Bank (ECB) have also cut rates (three and four times, respectively). Recent announcements around fiscal loosening in Europe may temper the pace of rate cuts slightly, but we still expect further cuts later in the year due to sluggish economic growth. Rates currently stand at 4.5% in the US and UK, and 2.9% in the euro area.

These dynamics suggest a more uncertain environment than at the start of the year and heightened volatility for US and European yield curves. However, we don’t forecast rate increases, which is supportive for short-dated bonds. These bonds are less sensitive to interest rate changes and potentially provide a safer investment during times of upheaval.

Why short-dated bonds?

Long term, the consistency of returns is a major selling point for short-dated credit. Over the past 20 years, short-dated credit has delivered 17 separate calendar years of positive returns, with only three negative years. This compares favourably with the all-maturity index, which had 14 positive and six negative years. This relative stability is largely due to short-dated credit's lower sensitivity to interest rate fluctuations, making it a more predictable investment option, especially in turbulent markets.

 

Short-dated credit also boasts a higher breakeven rate than the all-maturities index (see chart). The breakeven rate indicates how far yields can rise before the price loss from the index wipes out the annual yield. Due to its combination of attractive yield levels and low duration, short-dated credit can withstand larger increases in yields before returns are negated. This provides a buffer against interest rate volatility, reducing the risk of price unpredictability and enhancing liquidity. 

Step out of cash option

Money market funds have been, and remain, popular due to their attractive yields and liquidity profile, especially over the last few years. These funds provide quick access to assets with a T+1 settlement period (trade day plus one day), which compares favourably with most short-dated EMEA-based (Europe, Middle East and Africa) credit funds with T+3 settlement times.

With the possibility that rates will come down at a slower pace than previously thought, money market fund yields have fallen and are expected to continue to do so. As such, we anticipate that investors will eventually move out of money market funds in search of more attractive yields, most likely in short-dated corporate bonds.

We believe that a genuine alternative to cash must offer cash-like liquidity. Our short-dated strategy provides T+1 settlement, matching money market funds, while also seeking to enhance yield. Investors therefore won’t sacrifice flexibility for potentially superior returns.

Enhancing yield through diversification

While investing in ultra-short duration credit can provide investors with a very low-risk profile, the real value comes from finding additional yield without significantly adding risk. We believe there are three ways to achieve this, and all three should be used in a balanced manner to ensure consistent outcomes.

Firstly, investors can go down the ratings scale and selectively add lower-rated investment-grade bonds and some high-yield short-dated bonds. Secondly, investors can look further down the capital structure to invest in subordinated bonds from both financial and non-financial entities. Finally, investors can broaden their horizons and seek the best ideas globally, including Asian and emerging markets. This approach can potentially create a more diversified, higher-yielding, and stable portfolio compared with passive indices.

Final thoughts…

Markets are likely to remain volatile for the foreseeable future. Governments around the world are recalibrating in response to Trump 2.0 trade and defence policies. At the same time, we expect central bank policies to diverge as policymakers tackle their own growth and inflation challenges.

In today’s environment, we believe investors should consider an allocation to short-dated credit. Active managers with a global mindset can continue to find assets offering a compelling yield and realised return over cash, with only a moderate increase in risk. An ideal proposition in a turbulent world.