Themes and variations for bond markets

While fixed income markets will always be dominated by the Federal Reserve (Fed) and its decisions, significant themes are emerging that will impact markets next year. Considering how individual issuers may be affected by each is a critical first step. 

AI is a theme not only of markets but also corporate management teams. No one wants to be left behind by the successful adopters, but the why and how are massive challenges for management teams rooted in current patterns. The massive funding for the buildout of data centers has recently moved to the debt markets. The price impact on power and water needs in local communities is another issue to address. For most consumers and taxpayers, the current uses of AI are not enough to offset higher power and water prices. Supply and the structure of these issuances will be a focus and could continue to pressure spreads, the measure of risk relative to US Treasurys (UST), wider.

Another push on spreads could come from mergers and acquisitions (M&A) as announcements have surged in recent weeks. While at the outset these unions may seem positive, some are better than others. Selecting the winners and losers will be key for bond investors as the deals are consummated and the tricky work of integration begins. Supply is expected to increase by ~15% in 2026 over this year; a pick-up, but not at the levels experienced before the Covid time frame.

Private, not perfect

Private credit will continue to grow and to weigh on investor’s minds. The recent spout of stories around credit stress has cast a wide net of participants and sown seeds of doubt about how carefully these credits are vetted. Private credit emerged when smaller issuers needed a source of financing when the banks pulled back, but now the incredible amount of funds raised and relentless marketing of the products drives a need to lend and increasing competition among the lenders to place deals. With this behavior pattern, covenants and protections are weakening, which is not a good thing. The recent and quick collapses of a few names in the lower credit quality arena have captured the market’s attention. Private credit has its merits, but the investments are not marked-to-market and are not liquid. In this realm, negative surprises can be common as a deal that is seen likely to pay will be priced at par and then suddenly priced at zero. Look for the number of issuer defaults and liability exchange exercises to increase, while the total dollars involved will seem less significant.

A housing fix remains elusive

Affordability may have overtaken uncertainty as the word of the year. The consumer is the key to growth, but as this “K” shaped economy continues some are being left behind. So far, the focus has been on housing. While the Fed has shouldered much of the blame of high mortgage rates, the real burden is the lack of affordability. The low rates of the past have now limited mobility and reduced listings—current owners face the same affordability issues as first-time buyers. With reduced volumes, the spread between the 30-year mortgage rate and its 10-year UST base likely does not narrow. But home prices have also soared and affordability is at its lowest level since 2006. The administration will definitely take this issue on, but success could be futile if supply remains low and if mortgages hold near current levels. In some distorted way, the current housing recession likely has been a friend to inflation. Healthcare, a broad basket, will also face pressures from the administration as this segment continues to take a greater share of consumer’s wallets and dissatisfaction with insurance is rife. 

Employment front and center

Returning to the Fed’s mandate, housing affordability is one part, but what is driving the recent softness in employment? Less supply from an aging population and far less immigration? Or drastically dropping demand as inflation and tariffs require an adjustment of costs? Or is it that markets demand the consideration of AI costs in the corporate realm?

Employee retention matters, as hiring and training are costly. The mismatch of jobs available versus jobs that people want to do seems to be widening. A notable area of concern is dependent care, for both children and seniors, as low wages create a lack of demand for these positions from the labor population. Solutions are not easy but likely begin with all parties at the table rather than assertion of leverage from either side. 

Selecting winners and losers will be paramount as we enter the new year. And policy, as the critical mid-term elections grow nearer, will openly seek to support continued strength of markets. 

Taking the underlying credit sectors in turn:

Mortgage-backed securities (MBS) Spreads here have tightened over the quarter, to less than 30 basis points and well inside their FY24 year-end level of 43 basis points. The drivers remain the same, low volatility and potential for the US Treasury curve to steepen. Affordability is a key focus of the administration; however volume needs to be restored to home sales to reduce the spread of mortgage rates to their reference US Treasury (most often the 30-year mortgage to the 10-year UST). We have conviction on the steepening of the yield curve, which is a boost to MBS; however, the outside risk here is intervention in some element of the mortgage market that is not well executed.

Asset-backed securities (ABS) Spreads across the complex are wider than at the end of last year. Supply has been relentless of late and has increased over 7% relative to the comparable period last year. Investors continue to be focused on the potential ripple effects of the Tricolor collapse. This seems to be an isolated incident, as Tricolor’s business focus was subprime auto lending to lower income borrowers and undocumented immigrants, so the recent immigration policies were detrimental to their business model. Our process favors traditional ABS segments with a considerable focus on underlying credit quality. Supply likely continues into next year and will be met by solid demand, although with a renewed interest in credit fundamentals.

Corporate bonds Spreads of investment-grade (IG) securities have widened a little over the quarter as supply has increased and credit concerns emanating from the private markets have weighed. AI- associated issuance from the tech sector has dominated IG and the broader markets have also taken note. That said, this quarter’s movements have pushed spreads to almost flat to the end of last year/earlier this year. Earnings have been fine and supportive of credit quality, which has improved markedly. Credit quality of the IG Bloomberg US Corporate Bond Index has improved recently; the BBB portion of the index is at its lowest level in a decade at 46%

High yield (HY) Similar to IG, spreads here are wider over the quarter-to-date as investors assess whether the recent private credit issues are isolated or a warning sign (fraud v fundamentals). That said, spreads are fairly flat to the end of last year but tight relative to history. Defaults as measured by par value look low, at 1.0%, but increase to 2.5% when distressed exchanges are included. That’s the measure that we agree with, as an exchange or liability management event often only staves a bankruptcy off by two years or so. The number of companies experiencing events is an even better measure of this space, as small-to-mid-size companies are the borrowers. On an issuer weight basis, defaults are 2.0%, which almost doubles to 3.9% when those distressed exchanges are included. Moving into next year, a continued easing cycle is wind at the backs of these smaller companies, as any dollar not spent on interest cost is a boost. But, if private credit really deteriorates, the more liquid areas of distressed credit, namely publicly held high yield securities, may reflect the pain. As value-oriented investors, we remain cautious, deeming the risk/reward unfavorable. 

Emerging markets (EM) EM spreads have tightened over the quarter and year-to-date periods. This market provides three distinct ways to express conviction: sovereign debt, local currency, and hard currency corporate debt. Emerging market corporate debt has delivered robust returns YTD and has outperformed its developed market (DM) counterparts. EM corporate bonds are offering higher yields, despite issuers being predominantly top quartile producers in their industries and having materially lower leverage than DM equivalents. We think the US dollar will continue its descent, but not follow a smooth line, providing opportunities to adjust positioning. Should that prove untrue, it would test EM. 

Read more about our current views and positioning at Fixed Income Perspectives