Video transcripts layout 1 | Insight Investment

The chart shows that spreads are close to 20-year lows. While this can be justified in the central case, there is very little margin for error, which leads to a cautious directional view on credit.

However, when looking at yields, although they have declined, they remain close to 20-year highs. This raises a common client question: If spreads are low but yields are high, what should investors do?

The first answer is to keep it simple: stay invested, capture income, shorten duration, and build resilience. Investment grade yields remain attractive, and investors can capture around 90% of the income from bonds with maturities under five years while experiencing less than half the volatility. Much of the yield support comes from government bond yields, while credit spread curves remain very flat. Investors receive only a small amount of additional compensation for lending over much longer periods, despite significantly greater uncertainty. This is particularly relevant in high yield markets where default risks are more pronounced.

The second answer is to improve resilience by adding flexibility. Not all credit risk premia are priced equally. Different forms of risk include systemic risk, subordination risk, default risk, country risk, complexity risk, and illiquidity risk. Investment grade risk premia currently appear the most expensive, while country risk and complexity risk offer better value. Emerging markets are viewed positively due to supportive growth conditions, a weaker U.S. dollar, and growing diversification away from U.S. assets. Asset-backed securities benefit from fewer political and corporate-sector-related concerns.

Illiquidity risk is where private credit plays a role. Although illiquidity premiums have compressed over the last decade, private credit remains attractive, provided investors are selective about assets and managers. Equity markets have recently shown greater concern about private credit, particularly business development companies (BDCs) that lend to small and medium-sized enterprises. Concerns stem from lower expected income in a lower-rate environment and questions about underlying borrower quality.

If risks within private credit become more widespread, attention naturally turns to the insurance sector. U.S. insurers now allocate a significant portion of bond portfolios to private assets. While markets have expressed concerns about concentration risk, default rates in direct lending and loan markets have stabilized. In a scenario of stable growth and lower rates, defaults are unlikely to rise significantly. This creates opportunities for careful security selection within bonds issued by BDCs and insurers.

Another major theme is artificial intelligence. While future discussions may question whether AI is a bubble, today’s focus is on the enormous capital expenditure required to support the AI revolution. AI-related spending is expected to reach nearly 2% of U.S. GDP annually, providing a substantial boost to economic growth and labor markets.

AI has also become a significant theme in credit markets. Large companies are issuing more debt to finance AI-related investment, creating new security selection opportunities. Total AI-related capital expenditure could reach around $5 trillion over the next five years. Even if only a small portion is financed through public bond issuance, it could significantly increase the technology sector’s representation within global bond indices.

Unlike the dot-com era, today’s major technology companies are established, profitable businesses with strong cash flow generation. After accounting for shareholder returns and capital expenditure plans, many are still expected to generate positive free cash flow. This creates both opportunities and risks, reinforcing the importance of active security selection.

Bringing these views together, the overall outlook favors a tactical approach to duration. Expectations include moderate government bond yields and opportunities in relative value trades across different markets. The U.S. yield curve is expected to steepen, with shorter maturities responding to rate cuts while longer maturities remain influenced by fiscal concerns. Better value is seen at the long end of yield curves in markets such as the UK and Japan.

Within inflation markets, U.S. inflation expectations are viewed favorably compared with Europe and the UK. Agency mortgage-backed securities appear expensive following recent policy interventions. In currencies, the outlook favors long positions in the euro and Norwegian krone while remaining underweight the U.S. dollar and Swedish krona.

For credit markets, the positive economic backdrop is balanced by expensive valuations, resulting in a neutral overall stance on credit risk. Emerging markets and asset-backed securities remain attractive due to more favorable risk premia. Additional opportunities may emerge from spillover effects in private credit, particularly within BDCs and the insurance sector. At the security level, the focus remains on identifying winners and losers from AI-related capital expenditure and financing trends.