Credit defaults and spreads are expected to rise globally, credit portfolio managers said in the latest International Association of Credit Portfolio Managers (IACPM) Credit Outlook Survey.
The Aggregate Credit Default Index fell to -62.5 at the end of last month from -37.1 in June, showing more respondents expect defaults to rise in the next year. The Major Markets Credit Spread Outlook Index also dropped to -65.2 from -42.3, indicating more portfolio managers expect spreads to widen in the next three months. Both point to worsening credit conditions.
Som-lok Leung, executive director of the IACPM, noted that several factors are influencing these expectations. He said interest rates and movements in rate markets, especially U.S. Treasuries and sovereign bonds globally, were key topics at a recent IACPM Advisory Council meeting.
The initial impact
“As rates go up, the first to be affected are typically lower-rated firms,” Leung said. “Borrowing costs will rise and stress these companies first, which our members are already seeing.”
As rates rise, as is now widely expected, more pressure will fall on firms in weaker financial condition, such as high-yield companies, he added. The survey shows the high-yield sector is expected to be more affected as reflected in spreads. Discussions with IACPM’s bank members confirm the consensus expectation of higher defaults among these companies and signs of credit deterioration are already appearing, Leung added.
According to the IACPM report, several potential problems remain. On a macro level, respondents are very worried about geopolitics, inflation, interest rates, tariffs and energy security. Artificial intelligence (AI) tops the list of concerns, unsurprisingly.
Dan Sherry, U.S. CLO portfolio manager at MetLife Investment Management, said that given recent headlines and strong market reactions to AI-related news, AI-driven concerns could lead to higher price volatility across the market.
“While not yet a shock, I think general AI-driven concerns are already influencing overall market sentiment,” he said.
The combination of AI-driven disruption, higher interest rates, inflationary concerns, high commodity prices such as oil and jet fuel, and geopolitical uncertainty has created a heightened sense of concern about overall credit performance in the coming quarters, Sherry stated.
Leung also added that the AI component is complex and multi-faceted. “The longer-term concern is job disruption, while the near-term worry is the scale of AI-linked financing, not just data centers, chips and power but also the substantial amount of credit,” Leung explained. AI firms and hyperscalers have become major bank clients, and banks have taken on and distributed significant credit risk as a result.
Investors remain committed
Despite these challenges, Leung said investors still have some risk appetite. He added that significant institutional capital needs to be deployed. This demand is a key market driver.
Investor sentiment is now more fear-based, leading to wider spreads and heightened volatility.
MetLife’s Sherry said that investor sentiment is now more fear-based, leading to wider spreads and heightened volatility.
“We are seeing loan and bond prices move many points intraday in some cases,” he said.
Longer term, heightened volatility is likely a good thing for the CLO market as loan spread tightening has been persistent for roughly 2.5 years now, capping return opportunities. While greater credit losses challenge CLO managers, this environment also offers opportunities to identify attractive risk-adjusted returns in performing loans under pressure today, Sherry stated.
As for how credit spreads affect returns, Sherry said there are likely many performing loans that have traded down recently that will ultimately perform well over time. The challenge for CLO managers is maintaining the flexibility within CLO structures to minimize portfolio tail risk while simultaneously executing on the opportunities likely presenting themselves in the current market.
