Key Takeaways
- Market dispersion is widening across credit markets, increasing the importance of security selection and disciplined asset allocation.
- Artificial intelligence is a key driver of the dispersion, creating disruption risks that are manifesting prominently in loan spreads but is also creating opportunities for credits aligned to the associated revenue spend.
- With interest rate markets no longer a one-way bet, investors need to pay more attention to duration risks and the potential for yield offered by areas of the securitised market.
The most animated debate recently is less about the direction of markets per se, but about the growing divergence within asset classes. We have seen divergence in loans for some time – yet it is becoming harder to ignore in equities and among areas of the credit market. The result is an environment where broad index moves conceal dispersion, and where security selection and asset allocation need to do more work.
A tale of two markets
Within equities, recent strength in consumer staples, materials and industrials sectors in the S&P500 Index, alongside weakness in the technology sector, reflects a classic rotation: more defensive or value‑tilted segments holding up, while growth and mega‑cap tech cools.1 Investors are growing more sensitive to valuation and less willing to pay up indiscriminately for long‑dated growth.
Credit markets echo that split. Within high yield bond markets, credit spreads are tight in higher rated BB and B segments but there is notable widening among CCC-rated bonds.2 Higher quality loans remain highly sought after while more distressed names are unloved. This is evident in the software sector, for example, where worries about companies being disintermediated by artificial intelligence (AI) have seen spreads gap sharply wider.
Software sector leveraged loan spreads gap wider
Spread in basis points
Source: Bloomberg, S&P UBS Leveraged Loan Index, 28 February 2025 to 28 February 2026. Spread shown is the 3-year discount margin; this is the yield spread that when added to the floating rate reference rate (SOFR for USD-based loans) discounts all anticipated future cash flows (coupon and principal repayment) to the loan's current price (assuming the loan is repaid/refinanced in three years). A higher discount margin means the loan (or segment of an index) is trading at a lower price and vice versa. Basis point (bp) equals 1/100th of a percentage point. 1bp = 0.01%, 100bps = 1%. Past performance does not predict future returns.
In collateralised loan obligations (CLOs), senior tranches remain solid, while subordinated and mezzanine paper has been comparatively softer since the start of 2026, although a portion of this can be attributed to software representing around 15% of the loan index.3 It reflects a subtle shift in risk appetite. When sentiment gets ‘tetchy', investors gravitate towards capital structure seniority, while demanding a higher premium to own more levered exposures.
Fundamentals remain robust, but the market's tolerance for risk is diminishing somewhat and that tends to show up first in the places where the margin for error is thinnest.
AI: the "Spend = Revenue" loop
Artificial intelligence (AI) has been a key driver of dispersion. On the one hand, AI is a productivity driver, capable of lowering unit costs and accelerating growth. On the other, it introduces displacement risk. From software to insurance to logistics there are fears of business models being upended. A significant part of the downgrades seen in the loans sector can be traced to refinancing concerns surrounding software exposure and whether cash flows several years hence will be resilient.
But there is an important balancing point: one company's AI spend is another's revenue. Much of today's AI investment, particularly hyperscaler data centre investment, is being funded by large investment grade borrowers – and a portion of that spend flows through to lower‑rated suppliers and energy and infrastructure-linked businesses. This creates a potential bridge between ‘investment grade wallets' and ‘high yield revenues', and it may also benefit corners of securitised credit. Commercial mortgage-backed securities (CMBS) and asset backed securities (ABS), for example, could benefit as demand for certain property types and infrastructure-adjacent assets is supported by investment and capacity expansion.
Rates are no longer a one‑way bet
Another reason dispersion is rising is that rate uncertainty has increased. The past couple of years were characterised by broadly falling rates globally, which made duration-sensitive assets easier to own. Recall that bond prices rise when their yields fall and vice versa. As rate paths become less one-directional, however, breakevens matter more. This makes us more cautious towards investment grade bonds because when credit spreads are tight (and supply looks to be elevated) there is less cushion if yields rise.
At the yield curve level, a steepener bias is a natural expression of that view. It reflects the possibility that growth remains firm and inflation uncertainty persists, even as the front end is anchored by policy expectations. In this environment we see mortgage-backed securities as remaining attractive, offering a yield pick-up over treasuries and with limited pre-payment risk given that most mortgages were taken out at rates well below current levels.
Avoiding extremes
In environments like this we need to avoid extremes.
The first is an overly cautious view. Valuations may be rich, but history has shown that equity valuations can remain high and credit spreads remain tight for longer than sceptics expect, especially when growth is stable and liquidity is supportive. Avoiding risk can become its own risk if you wait on the sidelines for a correction that fails to arrive.
The second extreme is the opposite – fear not, the policy backdrop has our back. The narrative goes something like this: an accommodative Federal Reserve will step in if needed; government tax reimbursements in the US are on the way; Europe is leaning into defence and infrastructure spending; the US political cycle encourages running the economy hot into mid-term elections; and robust nominal growth will do the rest. To be fair, these are not unreasonable assumptions, but they can foster complacency.
In our view, the more useful stance is conditional optimism: acknowledge that the macroeconomic backdrop remains supportive, while accepting that dispersion and volatility create both risk and opportunity. That means outcomes will increasingly hinge on being nimble, leaning into short-term dislocations when markets overshoot, while staying alert to risks, especially those tied to technological disruption and refinancing conditions.
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1Source: Bloomberg, S&P500 sectors, 31 December 2025 to 27 February 2026.
2Source: Bloomberg, ICE BofA BB Global High Yield Index, ICE BofA B Global High Yield Index, ICE BofA CCC & Lower Global High Yield Index, at 27 February 2026.
3Source: J. P. Morgan Collateralised Loan Obligation AAA Index. J.P. Morgan Collateralised Loan Obligation High Quality Mezzanine Index at 27 February 2026.
Definitions
Collateralised Loan Obligations (CLOs) are debt securities issued in different tranches, with varying degrees of risk, and backed by an underlying portfolio consisting primarily of below investment grade corporate loans. The return of principal is not guaranteed, and prices may decline if payments are not made timely or credit strength weakens. CLOs are subject to liquidity risk, interest rate risk, credit risk, call risk and the risk of default of the underlying assets.
Commercial Mortgage-backed Securities (CMBS): A type of mortgage-backed security that is secured by the loan on commercial real estate properties rather than residential real estate.
High yield bond: Also known as a sub-investment grade bond, or ‘junk' bond. These bonds usually carry a higher risk of the issuer defaulting on their payments, so they are typically issued with a higher interest rate.
Investment grade bond: A bond typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments, reflected in the higher rating given to them by credit ratings agencies.
Loans: Also called ‘leveraged loans'. Loans to companies that tend to be rated below investment grade.
Mortgage-backed Securities (MBS): A security which is secured (or ‘backed') by a collection of mortgages. Investors receive periodic payments derived from the underlying mortgages (similar to the coupon on bonds), like an asset-backed security. Mortgage-backed securities may be more sensitive to interest-rate changes. They are subject to ‘extension risk,' where borrowers extend the duration of their mortgages as interest rates rise, and ‘prepayment risk,' where borrowers pay off their mortgages earlier as interest rates fall. These risks may reduce returns
Spread: The spread that loans pay over a benchmark interest rate. The difference in yield that a corporate bond pays over a corresponding government bond of similar maturity.
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