RJ: In terms of relative value and credit spreads in 2026, what do you think the outlook is?
Bobby: I think most market participants would agree that spreads are pretty tight. That’s been the market mantra for some time. It’s one thing to say that overall market levels are tight, but within sectors – and particularly within high yield – the dispersion of credits is actually at some of the tightest levels we’ve seen. There’s only about a 100 to 150 basis point difference from the first quartile to the third quartile, meaning the market isn’t really distinguishing much among credits right now. That creates value opportunities, particularly on the underweight side rather than the overweight side.
One area we’re particularly focused on – pivoting a bit toward the investment grade market – is the level of artificial intelligence (AI) spending and how it’s going to be funded. Estimates suggest that as much as 20% of the US investment grade market, which is roughly US$9 trillion, could consist of AI-related issuance over the next three to five years. That’s a huge and transformational number.
Our struggle with that is that fixed income, by its nature, is more of an equal weighted discussion than equities. In equities – think about the Magnificent Seven – the winners can definitely outpace the losers. So, the challenge on the fixed income side is to make sure that you are properly diversified. Even if everything works, you’re just getting pared back. So, this potential surge in AI related issuance leaves us a bit cautious – both on the sector overall and on AI spending within investment grade credit specifically.
There’s one more reason that makes us cautious. For a while, the mantra was that AI spending could be fully funded internally through cash flow.
RJ: That seems to have changed.
Bobby: Exactly. One of two things must be true: either that level of spending can’t be fully funded by cash flow, or issuers are looking at today’s environment and thinking this is a very attractive time to issue debt. If it’s that attractive for issuers, it may be time for investors to step back and try to look at the bigger picture.
RJ: The laws of supply and demand still matter. If we’re facing a surge in corporate issuance at the same time the US government continues to borrow more, it makes you wonder whether fixed income investors will step back and say, “I want a little bit more for my lending decisions.”
This potential surge in AI-related issuance leaves us a bit cautious – both on the sector overall and on AI spending within investment grade credit specifically.
Bobby: Up to this point, we’ve been pretty US-focused in the discussion around spreads. Mitch how do credit spreads look from where you’re sitting?
Mitch: The reality is, from where we’re sitting, that we are on the rich side of fair. I think the debate is to what extent are we in the rich side of fair? We would argue that spreads are not as rich as is discussed in the market, largely because when you look at spreads in a historical context, comparisons often fail to adjust for changes in duration, especially in high yield, and for the increase in overall credit quality.
We’ve done work adjusting for both factors. Yes, spreads are still on the rich side of fair, but not nearly to the extent often discussed. We’re about a year and a half from the widest duration levels and about a year inside long-term average. As is well known, the high yield market has also become increasingly comprised of double B spreads.
Adjusting for that, spreads are rich but we’re still got surprisingly strong earnings across most companies, a macro outlook that’s becoming more constructive, and very strong technicals. That is probably one of our bigger concerns.
Bobby: That’s a great point, especially regarding differences in duration across the aggregate index. One of the challenges managers face today is the widening difference between not just the quality aspect within the high yield sector, but the high yield duration compared to the IG duration. As you noted, that widening can skew the historical analysis.
Mitch: Lower duration products are inherently less volatile than longer duration products. In both high yield and investment grade, the volatility of credit spreads has actually been much lower than the volatility of interest rates.
That raises an important question: is the risk-free rate truly risk free? From a default standpoint, yes – but from a performance standpoint, with the fiscal challenges that we see in both Europe and the US, it does raise questions about the cost of the long end yields and curve dynamics.
Of course, we’ve got this deep neuron in our unconstrained strategies products as well. It raises interesting questions about what is risk, where does it sit in portfolios today, and what’s ultimately driving performance.
Find out more about our suite of credit products.
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