A flexible credit fund as a response to a more challenging environment

Credit assets ended the third quarter of 2026 on a softer note. While geopolitical and fiscal uncertainties warrant caution, resilient growth and solid corporate fundamentals remain supportive. At the same time, higher interest rates have increased embedded yields, offering more attractive carry and improved medium-term return prospects.

Credit indices have been under pressure since the beginning of the year, primarily due to the sharp rise in short-term rates across developed markets following the escalation of the conflict involving Iran and the United States. This higher-rate environment has mechanically weighed on bond valuations.

The prospect of persistently high energy prices and significant disruptions to global trade has fuelled inflation expectations and prompted a swift response from major central banks.

To contain the inflationary shock and prevent it from spreading to broader price components, central banks have embarked on a new tightening cycle: the European Central Bank has already raised rates twice, compared with one hike by the Federal Reserve, while both have adopted a more hawkish stance.

This shift in policy has led to a significant repricing of monetary policy expectations, with markets now pricing in three additional rate hikes on both sides of the Atlantic over the next twelve months.

The tightening already implemented, combined with expectations of further rate hikes, has driven a sharp rise in sovereign yields, with German yields increasing by 105 bps and their US counterparts by 142 bps.

This move has particularly weighed on Investment Grade credit, where lower carry and longer duration provide less protection against rising rates. However, the correction has also significantly increased embedded yields, enhancing carry potential and improving the medium-term return outlook for the asset class (see Figure 1).

Despite an environment characterised by persistently high interest rates, less supportive energy prices and abundant bond supply, leveraged finance markets have so far demonstrated remarkable resilience.

Abundant liquidity and investors’ search for yield have long provided financing to the most speculative business models, facilitating refinancing despite a gradual deterioration in credit discipline and capital allocation efficiency in recent years.

However, this support is beginning to fade. With rates experiencing their sharpest increase since 2022 and flows into certain leveraged finance segments starting to reverse, the vulnerabilities of some business models are becoming increasingly apparent.

This trend is particularly visible in private credit, which has long been shielded by lower liquidity and therefore less visible volatility, but also in riskier segments of liquid markets, including CLO equity tranches and CCC-rated corporate credit.

Against this backdrop, a widening in credit spreads appears natural to us, as the risk premia observed until recently no longer provide sufficient compensation for the fundamental and structural risks embedded in certain issuers.

We therefore expect greater dispersion across leveraged finance markets, creating a particularly favourable environment for security selection. This normalisation in valuations should broaden the opportunity set and enable active managers to generate attractive absolute and relative returns during the next phase of the credit cycle.

Late-cycle phases can be particularly challenging to navigate, given the growing number of sources of uncertainty, as illustrated by the current environment. Against this backdrop, capital preservation and disciplined issuer selection become increasingly important.

In credit markets, avoiding credit events remains one of the key drivers of long-term performance, as defaults and liability management exercises (LMEs) typically result in the crystallisation of losses.

While rising interest rates have weighed more heavily on some defensive credit segments, the decline in valuations has also resulted in a significant increase in embedded yields, enhancing their future return potential in the absence of credit events.

Against this backdrop, we believe Investment Grade credit offers particularly attractive potential for the coming months. Its greater interest-rate sensitivity and more resilient spreads could provide better protection in the event of an economic slowdown. It also represents a high-quality pool of liquidity that could be redeployed into riskier segments should market dislocations create more compelling opportunities.

Financial debt, particularly subordinated debt, has also suffered from the widening in sovereign spreads, especially in France and peripheral countries. However, we believe this move has been partly excessive given the structural improvement in bank fundamentals: stronger capital buffers over the past decade, well-controlled cost of risk and improved profitability in the current rate environment -which all provide support for European banks.

Current market levels are therefore creating attractive investment opportunities, particularly as the monetary tightening currently priced by markets appears demanding. The current environment allows investors to lock in attractive yields from Investment Grade issuers, while this exposure could also benefit from lower interest rates should the economic outlook deteriorate.

Finally, the credit market offers unparalleled depth and granularity, with tens of thousands of issuers worldwide. This broad opportunity set enables active managers to continuously identify attractive risk/reward profiles by exploiting market inefficiencies and selecting issuers whose fundamentals may be misunderstood or insufficiently valued by the market.

The Carmignac Portfolio Credit Fund was designed to navigate a wide range of market environments, with the objective of delivering attractive risk-adjusted returns throughout the credit cycle.

This ability to adapt was notably demonstrated during the periods of market stress in 2018 and 2020 when the Fund was able to limit downside during the market corrections before rapidly redeploying capital as market dislocations created more attractive opportunities, allowing the Fund to benefit from the subsequent recoveries.

The Fund Management Team draw on a broad investment universe to dynamically shift allocation between defensive assets and more speculative segments depending on valuation levels. Over the past twelve months, this approach has resulted in gradual profit-taking on structured credit and High Yield exposures, while increasing allocations to Investment Grade issuers.

With net High Yield exposure now at only 15%, after credit index hedges -which represent approximately 18% of net assets, and with a preference for defensive carry assets, we believe the Fund is well positioned to withstand a potential further widening in credit spreads.

A more pronounced market correction would also create opportunities: the Fund would have the flexibility to reduce its hedges and progressively reallocate towards High Yield credit at more attractive valuation levels, allowing it to benefit from a potential subsequent market recovery.

At the end of September, the portfolio offered an embedded yield of 6.5%, compared with 5.7% at the beginning of the year, while maintaining an average Investment Grade rating of BBB- and an interest-rate sensitivity of 4.0. This combination of enhanced carry, defensive positioning and significant redeployment capacity leaves the Fund well positioned to navigate a more selective environment while retaining the flexibility to capitalise on future market dislocations.