When will the music stop for credit…again?
Over the last few weeks, I have found myself asking a question that has become increasingly familiar: when will the music stop for credit markets?
Spreads have tightened to historical levels, yet the fundamentals supporting corporate bonds remain remarkably robust.
The past six months have been illuminating. Core sovereign bonds exhibited greater volatility than their corporate counterparts, an unusual dynamic that speaks volumes about where the real risks lie today. Some point to increasing government deficits, making traditional risk-free assets less so.
Others highlight that corporate balance sheets have remained unusually strong. I suspect both factors are at play, but there’s a third element that deserves attention, the quality shift within the corporate bond universe itself.
Quality migration
Something that is not being discussed in the media a lot is that the large number of companies, particularly those at the lower echelons of the quality spectrum, continue to fund themselves in private markets.
This means companies actually issuing debt in public high yield markets are of materially better quality than historical averages. Supply has been lighter than many expected for precisely this reason. This quality migration helps explain why corporate bonds look expensive versus government debt. The corporate bond issuer base has fundamentally changed.
That said, the wobbles we saw with First Brands and Tricolor reinforced the critical importance of due diligence. Yet despite these warnings, public credit markets continue to deliver excess returns.
AI infrastructure boom
A defining theme for 2026 will be the enormous costs associated with AI development.
Alphabet, Amazon, Meta, and Oracle all engaged in a record-breaking borrowing spree. Oracle’s experience was particularly instructive – their 40-year bond spreads widened 80 basis points, and the bond fell 13% by year-end.
This AI-related issuance wave helped vindicate our strategic preference for European over US investment grade. The dollar market is bearing the brunt of this infrastructure build-out, and I expect this to intensify. We’ve already seen a record-breaking start to 2026 in terms of supply.
At what point does the market’s ability to absorb mega-deals from tech companies reach its limit?
I don’t pretend to know the answer, but I’m increasingly comfortable sticking to the belly of the credit curve – five to seven years – for our allocation. Credit curves simply aren’t steep enough to compensate for the deluge of issuance at the long end.
“The central concern for me is that we’re likely past ‘peak’ fundamentals and ‘peak’ technicals in credit markets.”
Fragmented rate cycle
What strikes me most about the rates landscape is the increasing fragmentation of central bank cycles. The ECB looks on hold, Canada appears to have finished cutting, the Bank of England is expected to continue easing, and markets are pricing in a small hike from the Bank of Japan.
This desynchronisation creates opportunities. Bond yields have changed little over the past year, what I’ve called the ‘old normal’ returning.
What’s clear now is that investors anticipate geographic divergence to increase further.
The uncertainty around Federal Reserve independence adds another layer of complexity. Odds are we’ll see an interest rate dove appointed, but the bond market has already shown its scepticism. US interest rates have been cut, yet bond yields have failed to follow suit. Curves have steepened.
Past peak everything?
The central concern for me is that we’re likely past “peak” fundamentals and “peak” technicals in credit markets. Default rates are set to rise, particularly in Europe, though they should remain manageable.
More significantly, fallen angel risk is ramping up, with nearly $100 billion expected to enter high yield from investment grade this year.
The upgrade-to-downgrade ratio is expected to deteriorate. Rising M&A activity and deteriorating capital discipline – whilst providing impetus to equity markets – can create headwinds for credit.
All-in yields, while still relatively attractive, are notably lower than the 2025 average.
Fund selectors: Private credit “complement, not replacement”
Stock selection takes priority
I don’t expect much sector rotation driven by economic momentum in 2026. There’s little cyclical premium left to exploit.
Retail and consumer cyclicals didn’t underperform in 2025 despite employment concerns. Autos were the best performing sector in the US high yield. The sectors that suffered – media with a 14% default rate, and transportation – faced structural rather than cyclical issues.
This leaves me focused on idiosyncratic credit selection as the primary source of alpha. Chemicals might be one exception worth watching. The sector has performed poorly due to persistent headwinds from a prolonged downcycle and global oversupply. We dipped our toe in late 2025 with Celanese, which has performed well. The question now is whether to build a larger position.
Waiting for the dislocation
So, when will the music stop? I don’t know, and anyone who claims certainty is fooling themselves. What I do know is that with heightened geopolitical risk, we should get further chances to exploit market dislocations, as we did in April 2025.
There’s little fundamental reason in 2026 to doubt the credit market’s ability to continue trading in a narrow, expensive range. But markets rarely give you perfect entry points when you want them. Instead, they offer brief windows of opportunity during periods of stress or uncertainty.
The approach should be to remain patient, maintain a defensive sector allocation, focus on geographic opportunities where value exists, and be ready to act when those dislocations occur.
G7 yields are on aggregate well above inflation, so total returns should be positive. There’s plenty of geographic opportunity as cycles continue to desynchronise.
The music is still playing, but I’m keeping my eye on the exit and staying nimble. In markets like these, that’s often the best strategy.
