While the United States-Israeli war with Iran has resulted in a shift in the macro-economic outlook, there’s growing speculation amongst capital markets that the fallout of this war is yet to be sufficiently priced into the market. One of the most obvious fallouts is what’s happening on the inflation front; in short, market perceptions have seriously changed.
In stark contrast to the start of the year, when the U.S. Fed was pricing in two interest rate cuts, there are now no cuts in sight.
Meantime, while the European Central Bank (ECB) was pricing in no cuts only a few short months ago, it is now expected to hike three times.
Given that borrowers pay a benchmark rate plus a spread on any borrowings, the initial impact of the change in the macro environment on credit markets is pressure on benchmark yields.
While yields are higher, yield curves are also flatter across all major economies.
With central banks typically meeting up to eight times annually, there is still clearly the potential for change.
However, bondholders should remember that yields change daily, and the latest Middle East war started, the U.S. 2-year government bond rate has risen 40 basis points, while the 30-year rate has gone up 20 basis points.
Those unfamiliar with bonds need to be reminded that these moves are by no means insignificant.
Interestingly, while spreads have widened – with high-grade spreads up 10 basis points, high yield spreads are up 40 basis points – they remain well below long-term averages, and transactions are still getting done – albeit with cracks starting to surface.
Given that higher benchmark yields and higher spreads push costs up for borrowers, Brian Carney, a fixed income portfolio manager at Mawer Investment Management, questions what happens if this war continues to fester?
Admittedly, an end to the war will see prices of oil drop, while inflation may well subside.
But Carney reminds investors that the market will revert to its concerns around higher U.S. debt and deficits, which have only been intensified by this war.
“We don’t think investors are being compensated for owning longer duration credit priced off longer duration benchmarks,” Carney noted.
“We like shorter duration in an uncertain yield environment conflict or no conflict.”
While there are exceptions, in most cases, he questions whether investors are being compensated for owning lower quality credit.
Given that you’re not being compensated and there is under-pricing of downside risks in high yield, Carney warns investors not to reach for yield in this market.
Carney also flags challenges in private credit.
As a case in point, one of the risks is in AI debt, with new borrowers crowding into a market that is already quite expensive.
After borrowing around US$100 billion in 2025, he expects $150 billion in debt issuance in 2026, which will likely continue into 2027.
“The hyper scalers need to issue, and they don’t care about paying a few extra basis points to raise an extra $10 billion,” he said.
“So, we expect pressure on investment-grade spreads. Traditional borrowers will continue to issue, and in 12 to 18 months, the top 10 biggest global bond issuers could well be hyper scalers.”
Bottom line, Carney expects the losers to be lenders who lent first and in this market, he says it's important to be the lender who lends last: he provides two explicit portfolio examples.
The first is called CoreWeave, which is a middle-market AI revolution company responsible for the tech in data centres.
It’s sub-investment grade but currently yielding around 10% per annum.
The second is an agricultural chemical company that has been downgraded to non-investment grade, so it’s a fallen angel.
It has a number of asset sales planned and has a 2049 maturity bond trading at $0.60 in the dollar, providing an 8% yield to maturity.
“In recent times the market has been tilted in favour of borrowers over lenders… but there’s been decay in private credit and then it could spread out from there,” he concludes.
“Losses exceeded US$1 billion through unexpected bankruptcies such as Tricolour, which I see as a sign of decay.”
Overall, Carney claims there’s less confidence in tech and an increase in Payment-in-Kind (PIK) loans and substantial attempted redemptions in private credit funds.
Meantime, while the lack of liquidity has hit investors who didn’t understand what was going on, the U.S. Treasury is calling in insurers to discuss private credit risks, and the SEC is looking at rating agencies providing private ratings for private credit deals.
“The ECB and the BOE are looking at private credit, another sign of decay.”
