Credit considerations

Gallo: In terms of relative value and credit spreads in 2026, what do you think is the outlook there? Ostrowski: I think most market participants would agree that spreads are pretty tight. That's been the mantra of the market. You know I think it is one thing to say that overall market levels are tight, but within the sectors, and particularly within high yield, the dispersion of credits when you line them up, the lowest spread to the longest spread, is really at the tightest levels we have seen. It is only about 150 basis points from the first quartile to the third quartile, meaning that the marketplace isn't really distinguishing a whole bunch amongst credit itself and that creates value opportunities, particularly to play more so on the underweight side than the overweight side.

One of the things that we are particularly focused on, maybe pivoting a little bit to the IG market, is this notion of all the AI spend and how it is going to be funded. It's estimated that as much as 20 percent of the IG, the 9 trillion dollar US IG market, will consist of AI issuance within the next three to five years. That's a huge number and is a very transforming kind of number. Our struggle with that is that fixed income, by its nature, is more of an equal weighted kind of discussion than equities in the Mag 7. On the equity side, your winners can definitely outpace your losers. And there will be winners and losers. So, the challenge on the fixed income side is to make sure that you're properly diversified, cause if it all works you're just getting par back. So, that has us a little bit cautious on both on the sector in general and then the AI spend within the investment. One more thing on that: the mantra for a while was that AI spend would all be able to be funded internally from cash flow. Gallo: That seems to have changed. Ostrowski: That seems to have change a little bit, right? One of two things must be true: either that big spend can't all be funded by cash flow, or these issuers are thinking, wow, this is a really an attractive time based on where rates and spreads are. If it's such an attractive time for the issuer, it may be a time for the investor to step back and try to look at the bigger picture.

Gallo: The laws of supply and demand still matter. So, if we are going to have a surge in issuance at the same time the United States government continues to borrow more and more, it makes you wonder if fixed income investors will step back and say, I want a little bit more for my lending decisions. Ostrowski: To this point in the spread discussion, we've been pretty US focused. Mitch how do spreads and the credit markets look from where you're sitting? Reznick: The reality is, from where we're sitting is clearly 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 not as much as is discussed in the market, principally because when spreads are looked at in a historical context, they are not often adjusted for changes in duration in the high yield market in particular and also the increase in overall credit quality. Now, we've done some work adjusting for both of those. Yes, we are on the rich side of fair, but not nearly so--we're about a year and a half from the wides in duration and about a year inside long term averages for duration. As is well known, the market has also become increasingly comprised of double B spreads. Adjusting for that, yes, we are on the rich side of fair, but also we've got surprisingly strong earnings for the majority of companies, macro outlook is increasingly getting more constructive, and technicals have been pretty strong. That is probably one of the biggest concerns, actually.

Ostrowski: You bring up a really good point on some of the duration differences within the aggregate index. One of the challenges managers have to deal with 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. That widening can, as you say, skew some of the historical analysis. Reznick: And that may, you know, lower duration products are inherently going to be lower volatility than longer duration products in both high yield and investment grade. And the volatility of credit spreads has actually been much less than the volatility of rates. Is the risk free rate so risk free? Clearly it is from a default point of view, but from a performance point of view, with the fiscal challenges that we see in both Europe and the US, it does raise questions about the cost of the long term, the long end of the curve. And of course, we've got this steepener on as well in our unconstrained strategies products. But it also raised interesting questions about what risk is, where is risk and what is driving performance at risk.