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.

The credit market appears healthy based on tight average spreads, but this is misleading. A strong top 90% of the market pulls the average down, while the bottom 10% faces severe distress, with loans "dropping like a stone." The weight of prolonged high borrowing costs is creating a clear divide between healthy and struggling companies.

The CCC-rated segment of the high-yield market should not be treated as a simple down-in-quality allocation. Instead, it's a "stock picker's" environment where opportunities are found in specific, idiosyncratic situations with high conviction, such as a turnaround story or a mispriced part of a company's capital structure.

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 massive ~$1.5 trillion in debt financing required for AI infrastructure will create a supply glut in the investment-grade (IG) bond market. This technical pressure, despite solid company fundamentals, makes IG bonds less attractive. High-yield (HY) bonds are favored as they don't face this supply headwind and default rates are expected to fall.

Judging the credit market by its overall index spread is misleading. The significant gap between the tightest and widest spreads (high dispersion) reveals that the market is rewarding quality and punishing uncertainty. This makes individual credit selection far more important than a top-down market view.

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.

A significant shift in corporate finance strategy has occurred: companies no longer universally strive for an investment-grade (IG) rating. Many firms, including 'fallen angels' downgraded from IG, are content to operate with a high-yield rating, finding the higher borrowing costs acceptable for their business models.

A surge in investment-grade bond issuance to fund AI capital expenditures will insulate the high-yield market. This technical factor is expected to drive high-yield bond outperformance versus higher-quality corporate bonds, which will face supply pressure.