Fast reading
- In May, Moody’s stripped the US of its triple-A credit rating, leaving the world’s largest economy without a top rating for the first time in over a century.
- The volatile market conditions support the case for a flexible and dynamic multi-asset credit investment approach.
- An unconstrained strategy has the ability to adapt to market conditions and can pull multiple performance levers to try and optimise results.
US President Donald Trump has adopted a scattergun approach to his implementing flagship tariff scheme since taking office in January.
In the space of few weeks, the US imposed 145% tariffs on China – the world’s second-largest economy – only to back peddle and drop them down to 30%. The US trade court ruling on 28 May that Trump’s ‘liberation day’ tariff scheme is illegal only adds to the sense of confusion. The US administration is appealing the ruling.
Beyond the economic impact of the tariffs themselves, the abrupt back-and-forth rollout has caused a lot of uncertainty and left markets in a bit of a holding pattern. It is hard to set out a long-term position when a single social media post can add – then wipe out – US$2.4tn of market value in seven minutes.
Meanwhile, rising levels of government debt and a widening budget deficit in the world’s biggest economy led Moody’s1 to strip the US of its triple-A credit rating for the first time in over a century.
The volatile and uncertain market conditions support the case for a flexible and dynamic multi-asset approach to credit investment.
An unconstrained strategy can adapt and respond to choppy and turbulent conditions, and has the ability to pull multiple performance levers to potentially generate alpha.
Figure 1: Taking an unconstrained approach
Note: The unconstrained strategy does not have a benchmark. The comparison depicted in figure 1 serves to demonstrate the difference between an unconstrained and other approaches to credit investing.
An option overlay
One such lever is an option overlay2 which seeks to hedge against downside risk. It is intended to allow for a degree of adjustment to the portfolio’s risk level, depending on prevailing market conditions, while limiting turnover. The reduced volatility also adds to the potential for strong risk-adjusted returns.
These levers also extend to sub-asset class opportunities. For example, structured credit – particularly asset-backed securities (ABS) – can be another driver of outperformance.
Asset-backed securities are a vital part of the financial system, providing liquidity and funding for a range of consumer and commercial loans and leases.
ABS offer a way for lenders to free up capital and for investors to gain exposure to different types of assets. They play a crucial role in the financial ecosystem by enhancing liquidity and providing investment opportunities.
An unconstrained strategy can adapt and respond to choppy and turbulent conditions
Positioning our Strategy
Fundamental to any market outperformance is portfolio positioning. We have identified several pockets of opportunity amid such an uncertain market backdrop.
Financials, for example, have been resilient through the tariff-talk. Banks, particularly in Europe, are fundamentally sound with solid capital ratios following years of balance-sheet repair and revenues are supported by a range of factors including falling deposit costs, and higher income streams. Finally, financials are largely out-of-scope from direct impact of a tariff war.
We see evidence of fresh buybacks driven by capital strength and there does not appear to have been any demonstrable deterioration in asset quality.
The Federated Hermes Unconstrained Strategy has an overweight positioning in AT1s (convertible fixed income instruments primarily issued by financial institutions), which has bolstered our performance in recent months.
Where next?
The Trump administration has demonstrated a flexibility to back peddle from the more strident elements of its tariff programme.
It’s an optimistic signal and could encourage a more ‘risk-on’ approach from many investors going forwards.
As we have previously seen, mostly notably in the autumn of 2024, a more risk-on environment can present buying opportunities in the options market. We are anticipating another entry point before adding further protection to the portfolio.
We expect to continue to see opportunities between the US and Europe in particular, given the events unfolding in the US together with the hope that austerity is easing in Europe. Elsewhere, and the volatility from tariffs is providing attractive potential opportunities in emerging markets (EMs).
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1 Source: Ratings.Moodys.com/ratings-news/443154
2 Option overlay strategies can be constructed to mitigate systematic risk, enhance portfolio income, or improve risk/return, enabling investors to efficiently achieve long-term portfolio objectives. Overlays can use derivative investment vehicles to obtain, offset or substitute specific portfolio exposures, beyond those provided by the underlying portfolio assets.
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