Since then, a semblance of stability has returned. Trump has softened his rhetoric on tariffs, while the Powell dismissal is off the table. Government bond yields now appear to be functioning normally again. Within credit markets, the spread widening appears to have peaked (for now). Moreover, the recent move wider in spreads has taken us from compressed levels back to the average spread level of the past 10 years. 

Nonetheless, volatility will remain the watchword for the foreseeable future. Against this backdrop, we think investors looking for steady returns, with the potential for cash-like liquidity for minimal additional risk should consider a short-dated enhance income strategy.  

The Fed and ECB: divergent challenges

The Fed and the European Central Bank (ECB) are grappling with distinct economic and inflationary challenges. The US faces a combined demand and supply shock, pushing inflation higher. It's uncertain whether this is a one-off price level shock with a transitory impact on inflation or a more fundamental issue that the Fed must counteract. In contrast, the ECB is dealing with a pure demand shock, which is easier to manage through rate cuts as they don't fuel inflation.

As it stands, we expect the ECB to cut rates two more times this year, making it five cuts in total, bringing the rate to 1.75%. We anticipate the Fed will cut rates twice this year, up from an earlier forecast of one cut, with the Fed Funds Rate dropping to around 3% by the end of next year.

However, significant risks loom. A US recession, once a distant prospect, now feels dangerously close (around a 45% probability). This scenario would likely prompt further ECB easing and could see the Fed acting more aggressively. There's also the risk that the Fed might do less than the market expects as policymakers strive to keep long-term inflation expectations anchored. Add in concerns about the Fed's independence, and it's clear why markets are so volatile.

It’s also why we advocate an allocation to short-dated bonds, which are less prone to interest rate risk. What else do they offer? 

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 by seeking the best ideas globally, including in Asian and emerging markets (EM). This approach can potentially create a more diversified, higher-yielding, and stable portfolio compared to passive indices. While concerns about a global trade war impacting EM nations are valid, these markets hold a significant comparative advantage in goods production—a dominance that won't vanish overnight. Moreover, decoupling from China means rerouting goods through other EM countries, with China still maintaining its dominant industrial base.

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.