Navigating Credit Markets in an ‘Everything Rally’

I doubt Twain had credit defaults in mind when he made this quip, but amidst the recent news flow on credit markets, you’d be forgiven for thinking they were about to implode.

This sentiment is understandable; 2025 saw an ‘everything rally’ whereby assets across the risk spectrum, from equities to corporate bonds to gold, posted strong returns. As such, concerns regarding valuations are rife, with many commentators keen to speculate on what might be the first domino to fall.

Whilst US tech stocks have taken their share of the flack, many have also landed on credit markets and are asking whether recent defaults in the US (Tricolor and First Brands) and closer to home (Market Financial Solutions) indicate broader issues are coming.

With negative headlines focusing on pockets of stress, investors are right to question whether a credit default cycle is coming.

Reminder: investing in credit involves taking credit risk

Whilst this sounds obvious, it has been easy for investors to forget defaults are not just possible, but an expectation of investing across the cycle (particularly in sub-investment grade areas) – having been accustomed to very low default rates following the financial crisis.

That said, default rates haven’t been zero in recent years – they’ve just been dismissed as idiosyncratic. High-profile credit events (Credit Suisse, Thames Water, Altice) have certainly attracted headlines, but concerns of contagion risk have quickly been dismissed by a market intent on rallying.

Investors concerned by default risks should consider their exposures and assess whether they’re being adequately compensated for their credit risk exposure.

To limit default risk, it makes sense to go up in quality

Looking forward, if an investor is concerned around potential credit losses from a weakening global economy, common sense suggests they should move into higher quality bonds with lower default risk. Traditionally, this has involved investing in government and investment grade corporate bonds.

Whilst logical, we see limited value in these areas given government bonds offer little/no pickup versus cash and corporate bond spreads are very tight.

In addition, whilst both have low credit default risk, they don’t necessarily exhibit low volatility (see below). Both are particularly exposed to interest rate risk; whilst this may benefit investors if interest rates fall, the opposite is true if they rise. We consider this to be an unrewarded risk over the long term which introduces volatility and can offset the benefits of lower default risk.

So, what’s the solution?

Whilst we are keen to increase credit quality across our portfolios, reducing risk often comes at the cost of yield and return potential. Hence, we utilise alternative types of credit that we believe can generate a higher yield than traditional credit, whilst not compromising on credit quality.

Asset-backed securities (‘ABS’) are a key strategy we utilise to achieve this. ABS funds invest in bonds that are backed by a pool of diversified assets, such as mortgages, rather than individual businesses. This diversifies corporate exposure by introducing alternative underlying risks, such as consumer and real assets, whilst often providing a greater yield than corporate bonds for a given credit rating.

Hang on, isn’t ABS risky?

Anyone who’s watched The Big Short will know ABS often remains tainted by 2008, but today’s structures are much more robust and are designed to withstand heavy default scenarios. This has been driven by regulatory reform, which has led to originators retaining skin-in-the-game, greater transparency, and less debt in ABS structures.

Unlike traditional corporate bond strategies, ABS strategies aren’t ‘first-loss’ exposures. In other words, in a corporate bond strategy, any defaults flow directly through to credit investors and impact returns. Conversely, initial defaults in an ABS pool are absorbed by equity holders in the ABS structure, who are subordinate to the debt holders. Our exposure is to the senior debt tranches to utilise this protection.

ABS strategies have meaningful allocations to collateralised loan obligations (‘CLOs’), which is debt backed by sub-investment grade corporate loans. Whilst defaults do occur in loan markets (1-3% in recent years – source: Apollo), CLOs are well-protected against them.

The below table quantifies this protection by mapping combinations of defaults and recovery rates in the underlying loan pool required to generate losses to CLO debtholders.

For example, even typical BB rated (i.e. sub-investment grade) CLO tranche requires total cumulative defaults of 50% at a 50% recovery rate to incur any default losses to the BB CLO bondholder. We believe this represents a draconian scenario and note even greater shocks are required to impair investment grade CLO tranches.

So, I needn’t be worried?

We’re not trying to convince anyone that markets aren’t expensive and there are no signs of stress. We acknowledge exogenous events could lead to a correction which would test credit markets’ robustness.

However, the important thing is to ensure investors are well-protected in advance of any market stress. We advocate increasing credit quality to ensure portfolios are robust whilst utilising areas such as ABS to diversify fixed income exposures and contribute to strong yield-driven returns.

To bring this full circle, I’m not sure whether Mark Twain ever invested in credit. But if he did, he might say “There are two times in a person’s life when they shouldn’t speculate: when they can’t afford it, and when they can.”