Money managers selling mortgage-backed securities (MBS) are unlikely to rotate directly into corporate credit. Despite being underweight corporates, current tight valuations make them unattractive. Instead, managers will likely hold cash and wait for a better entry point from the expected record primary issuance in the corporate bond market.
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A strategic divergence exists in EM corporate credit. Mandate-bound real money funds feel compelled to stay invested due to a lack of near-term negative catalysts, while more flexible hedge funds are actively taking short positions, betting that historically tight spreads will inevitably widen over the next 6-12 months.
A surge in corporate spending on AI, capex, and M&A can boost stock prices. However, this same activity often requires issuing large amounts of new debt, increasing supply and causing credit spreads to widen, leading to underperformance versus equities.
While default risk exists, the more pressing problem for credit investors is a severe supply-demand imbalance. A shortage of new M&A and corporate issuance, combined with massive sideline capital (e.g., $8T in money markets), keeps spreads historically tight and makes finding attractive opportunities the main challenge.
Traditional credit rotation strategies based on beta and starting spreads have become ineffective. Analysis now shows a sector's net supply—the volume of new debt issued versus what's maturing—is the most critical factor determining its relative performance, making technicals more important than fundamentals.
In a market where everyone is chasing the same high-quality corporate bonds, driving premiums up, a defensive strategy is to pivot to Treasuries. They can offer comparable yields without the inflated premium or credit risk, providing a safe haven while waiting for better entry points in credit markets.
Due to tight credit spreads, Richard Bernstein Advisors (RBA) has taken the unusual step of eliminating all corporate credit exposure from its portfolios. They favor agency mortgage-backed securities, which currently offer a similar or better yield without the associated corporate downgrade or default risk.
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.
Despite forecasting a massive surge in bond issuance to fund AI and M&A, Morgan Stanley expects credit spreads to widen only modestly. This is because high-quality, highly-rated companies will lead the issuance, and continued demand from yield-focused buyers should help anchor spreads.
Sectors that have experienced severe distress, like Commercial Mortgage-Backed Securities (CMBS), often present compelling opportunities. The crisis forces tighter lending standards and realistic asset repricing. This creates a safer investment environment for new capital, precisely because other investors remain fearful and avoid the sector.
Massive government issuance is crowding out private credit and making sovereign bonds inherently riskier. This dynamic is collapsing credit spreads and could lead to a market where high-quality corporate bonds are perceived as safer than government debt, challenging the concept of a 'risk-free' asset.
