Given the outlook for increased debt issuance from large US corporations to fund expansion, Morgan Stanley sees better opportunities in assets less exposed to this trend. They favor high yield bonds over investment grade and believe European credit may outperform as it lags the US "animal spirits" theme.

Unlike in past cycles, the riskiest underwriting has largely occurred in leveraged loans and private credit, not high-yield bonds. This migration has left the public high-yield market with higher-quality issuers and shorter durations, making it more resilient than its reputation suggests.

Aggressive liability management exercises (LMEs) are most effective on long-duration debt trading at a discount. As the high-yield market’s average duration has shortened to under three years, the timeframe and opportunity for companies to execute these complex restructurings has become significantly more limited.

Counterintuitively, high-yield corporate bonds are expected to perform better than investment-grade credit. They do not face the same supply headwind from AI-related debt issuance, and their fundamentals are supported by credit team forecasts of declining default rates over the next 12 months.

The high-yield bond market is now nearly 60% BB-rated, a significant quality improvement over the last decade. Risk has instead concentrated in the lower-quality, B-rated leveraged loan and direct lending markets, making high-yield spreads an unreliable gauge of overall credit stress.

Today's high-yield market has a fundamentally different, higher-quality composition than before the GFC. The proportion of risky CCC-rated issuers has fallen from nearly 25% to below 10%, which mathematically justifies the current tight spread levels.

With credit curves already steep and the U.S. Treasury curve expected to steepen further, the optimal risk-reward in corporate bonds lies in the 5 to 10-year maturity range. This specific positioning in both U.S. and European markets is key to capturing value from 'carry and roll down' dynamics.

The high-yield market's credit quality is at an all-time high, not due to broad economic strength, but because of a massive influx of 'fallen angels.' Downgrades of large, formerly investment-grade companies like Ford and Kraft Heinz have structurally improved the overall quality of the index.

The modern high-yield market is structurally different from its past. It's now composed of higher-quality issuers and has a shorter duration profile. While this limits potential upside returns compared to historical cycles, it also provides a cushion, capping the potential downside risk for investors.