An excerpt from a Mawer podcast, ‘Art of Boring’ with Portfolio Manager, Brian Carney
Against the backdrop of geopolitical escalation, an energy shock and shifting rate expectations this podcast discusses the outlook for global fixed income markets.
There’s been a shift in the macro economic outlook given the US and Iran conflict, however the concerns are largely priced out of the market.
Inflation is expected to feed through to interest rates. At the start of the year the US Fed was pricing in two interest rate cuts, now there are no cuts. The ECB was pricing in no cuts but now expect to hike three times. Market perceptions have changed.
Borrowers pay a benchmark rate plus a spread on any borrowings, so the first impact of the change in macro environment on credit markets is pressure on benchmark yields.
Central banks meet seven to eight times a year so seven to eight times there is potential for change. However, yields change every day.
Since the start of the conflict, the US 2 year government bond rate has gone up 40 basis points and the 30 year rate has gone up 20 basis points. These are big moves.
Yields are higher, yield curves flatter and that’s true amongst all major economies.
Spreads have widened, but not by all that much given the uncertainty. High grade spreads are up 10 basis points whilst high yield spreads are up 40 basis points. That still leaves credit spreads well below long term averages.
The combination of higher benchmark yields and higher spreads means costs are up for borrowers but not noticeably yet. Transactions are still getting done and there is value in high quality but there are cracks elsewhere.
One of the questions is, ‘What happens if the conflict is resolved?’ Then the prices of oil will go down and inflation will subside but the market will go back to being concerned about higher U.S. debt and deficits, which have been exacerbated by the conflict.
Also read: Record Highs, Unresolved Risks: Markets Look Through The Noise
We don’t think investors are being compensated for owning longer duration credit priced off longer duration benchmarks.
We like shorter duration in an uncertain yield environment conflict or no conflict.
In most cases we don’t believe investors are being compensated for owning lower quality credit. There are exceptions, but generally we don’t see any value so our portfolio is defensive.
Portfolio duration is little over a year with high quality investments. High yield makes up about 9% of the portfolio and is only in a few credits.
Don’t reach for yield in this market, as you’re not being compensated and there is under-pricing of downside risks in high yield. There are also challenges in private credit.
One of the risks is in AI debt with new borrowers crowding into a market that is already quite expensive. After borrowing around US$100 billion in 2025 we expect US$150 billion in debt issuance in 2026, that will likely continue into 2027. The hyper scalers need to issue, and they don’t care about paying a few extra basis points to raise an extra US$10 billion. So, we expect pressure on investment grade spreads. Traditional borrowers will continue to issue and in 12 to 18 months the top 10 biggest global bond issuers could well be hyper scalers. We expect the losers to be lenders who lent first. In this market you want to be the lender who lends last.
I wanted to give two explicit examples in our portfolio.
The first is called CoreWeave, it’s a middle market AI revolution company, responsible for the tech in data centres. It’s sub investment grade but currently yielding around 10% per annum.
The second is an agricultural chemical company which has been downgraded to non investment grade, so it’s a fallen angel. It has a number of asset sales planned and has a 2049 maturity bond trading at $0.60 in the dollar, providing an 8% yield to maturity. We see that there’s value there.
In recent times the market has been tilted in favour of borrowers over lenders. There’s been less to differentiate between issuers. But there’s been decay in private credit and then it could spread out from there. Losses exceeded US$1 billion through unexpected bankruptcies such as Tricolour, which I see as a sign of decay.
There’s less confidence in tech and there’s been an increase in PIK loans and substantial attempted redemptions in private credit funds. The lack of liquidity has hit investors that didn’t understand, which I also see as a sign of decay. The US Treasury is calling in insurers to discuss private credit risks, and the SEC is looking at rating agencies providing private ratings for private credit deals. The ECB and the BOE are looking at private credit, another sign of decay.
Jamie Dimon, CEO of JP Morgan, in his annual letter said:
“I do believe that when we have a credit cycle, losses or leveraged lending in general will be higher than expected. This is because credit standards have been modestly weakening pretty much across the board. Also, by and large, private credit does not have great transparency or rigorous valuation marks on their loans. It has always been true that not everyone providing credit is necessarily good at it. We have not had a credit recession in a long time, and it seems some people assume it will not happen.”
In closing, the optimist will dismiss bad news as random and this is a sign of decay. Others will say public and private markets are distinct markets.
Pessimists like me say if it hurts in one market, it can lead to hurt in another market. If you feel tremors, evacuate the mountain side. Investors that are all in could be hurt and those in a position to take advantage, could be given one of the rarest opportunities.
