Tight credit spreads are attracting issuers but offer little protection to investors if AI optimism fades or geopolitical risks, such as recent events in Iran, trigger a “risk-off” environment. US high-yield bond spreads of 289 basis points (bps) sit in the bottom decile of observed values. Similarly, although US investment-grade corporate spreads have risen slightly since reaching post-GFC lows in January, they remain in the lowest quartile on record. Spreads in adjacent markets also reflect stretched valuations: for example, commercial mortgage-backed security (CMBS) spreads have dramatically tightened over the last two years despite rising delinquencies.

Accelerating AI-driven capex could boost supply and put pressure on spreads. According to Morgan Stanley, gross US investment-grade supply will rise approximately 25% to a record $2.25 trillion in 2026, driven in part by hyperscaler and related infrastructure issuance rising to $400 billion—roughly 10x what they raised in 2024. Structured credit markets will also see surging supply, with data center securitizations expected to rise nearly 50% to more than $30 billion. Issuance is already well underway; Alphabet and Oracle together issued nearly $60 billion of new debt in February alone.

The financing of this AI-driven buildout will span the capital structure. Senior unsecured bonds will be the primary vehicle for large, investment-grade issuers. However, asset-backed securities (ABS) and project finance debt are increasingly being used, especially for data centers. The ABS market is seeing innovation as data center cash flows are securitized to tap new pools of capital. As financing structures evolve, investors need to ensure they have a clear picture of leverage and risk. In some data center deals, for example, tenants effectively backstop the project, yet the transaction nonetheless sits off balance sheet, obscuring its risk profile.

The potential mismatch between the useful life of AI-related assets and the maturity of the debt used to finance them also warrants close attention. While demand for data center computing resources is currently robust—for example, waitlists for AI chips and capacity are common—future data center demand is uncertain. If AI models become more efficient or if a technological leap reduces the need for processing power, chips and the buildings that house them could become obsolete before their debt is repaid. This would threaten a variety of different debt instruments, including asset-backed deals that finance chip purchases, securitizations backed by data center revenue, and unsecured debt. The fiber optic buildout of the early 2000s offers a cautionary parallel: overbuilding led to years of excess capacity and financial distress for some issuers, though the long-term utility of fiber ultimately proved out.

Strong fundamentals help offset some of these risks. Many hyperscalers have high (AA or AAA) credit ratings, reflecting low leverage, strong free cash flow, and ample liquidity, making them well-positioned to absorb additional debt. However, not all players in the AI ecosystem generate such healthy operating cash flows, and even those that do will see capex demanding a growing share of this over the next several years. Utilities and REITs that own and operate data centers are taking on significant leverage to fund expansion but often start with different fundamentals. Utilities, for example, often carry BBB ratings, and some data center operators have “junk ratings,” a sticking point in recent financing deals.

Historically low credit spreads, in our view, do not sufficiently compensate investors for current risks, which include obsolescence and rising structural complexity. Given these challenges, credit exposure should remain within policy targets, and higher-quality structured credit, such as agency-backed mortgage securities, should be considered as a substitute for corporate bonds that offer only marginally higher yields but greater vulnerability to cyclical and technological risks. Investors in AI-related credits should focus on high-quality issuers with strong balance sheets and stable revenue streams. Complexity should be accepted only when compensated by a meaningful premium.

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by TJ Scavone

Yields on most major developed market (DM) sovereign bonds reached a multi-year high in 2023 and have since held just below those highs, trading in a relatively narrow range. We expect this pattern to persist into 2026, supported by a resilient yet uncertain economic and policy backdrop, fair valuations in most markets, and ongoing yield curve pressures. Investors should keep allocations to high-quality sovereigns closely aligned with policy guidelines.

Looking ahead to 2026, the environment for most high-quality sovereigns remains broadly supportive. Economic growth is healthy but slowing—DM real GDP is projected to rise 1.7% in 2025, down from 1.9% in 2024, with most of the deceleration in the United States. While US consumer spending remains supportive, the labor market has softened, and the full impact of tariffs remains uncertain. These dynamics are likely to keep the Fed and other major central banks biased toward modestly easing in 2026, despite persistent inflation concerns. Overall, softer labor markets, tariff headwinds, and resilient but softer growth—supported by healthy consumer spending, AI capex, and easier policy—should limit both recession and inflation risks, resulting in modestly lower policy rates in many markets and rangebound sovereign bond yields in 2026.

Given this backdrop, we recommend maintaining exposure to high-quality sovereign bonds, with duration risk kept in line with benchmarks. The case for a short-duration stance has weakened as short-term rates have declined and yield curves have steepened, raising the opportunity cost of holding cash. Likewise, the case for adopting a long-duration stance is not compelling. Long duration typically outperforms when growth slows and central banks ease, but we anticipate only limited monetary easing. The European Central Bank and Bank of England have already delivered most of their anticipated cuts and markets are pricing in around 75 basis points (bps) of Fed cuts in 2026—a scenario that looks optimistic, considering current risks. Additionally, sovereign bond yields in key markets, like the United States and euro area, are currently in the bottom half of what we consider their fair value ranges, leaving little room for further declines absent a recession.

There are risk factors that warrant close attention. We have recently seen longer-duration sovereigns underperform as a range of influences—including fiscal concerns, elevated macro volatility, and cyclical factors—have put upward pressure on yields further out the curve. Fiscal pressures in particular have repeatedly made headlines in recent years, with many DM countries facing challenging fiscal outlooks and heightened volatility around budget stand-offs. While fiscal pressures warrant monitoring, market pricing does not signal imminent fiscal crisis, nor are they the sole driver. Elevated macro volatility, structural headwinds, and cyclical factors like monetary policy have also contributed. Many of these influences should reverse in a growth shock, allowing bonds to rally and provide portfolio ballast, as seen at points this cycle. However, with these crosscurrents, investors should demand more attractive yields before adding exposure. For context, yields would need to rise another 130 bps–180 bps to reach the upper end of their implied fair value range in the United States and Germany. Some regions offer more value, but domestic and currency risks need to be considered. In most cases, we recommend waiting for more attractive US Treasury valuations—given global spillover effects—before extending duration risk.

Overall, we anticipate that bonds will outperform cash in most major markets—supported by steeper yield curves—and should maintain their defense role in a downturn. However, since current bond yields are not especially attractive relative to our fair value estimates, we recommend maintaining allocations at policy levels, and keeping duration risk closely aligned to benchmarks.

Investors should underweight public corporate credit in 2026

by TJ Scavone

At present, the public credit universe offers few compelling opportunities. While returns have been solid and fundamentals remain sound, public credit is increasingly a one-sided trade. Spreads for both investment-grade and high-yield corporates are near historic lows, and the economic backdrop is turning less supportive. We see potential for spreads to widen in 2026 and beyond, and as a result, we favor higher-quality spread products that offer better relative value and more diversified return streams.

US investment-grade corporate bonds returned 6% annualized over the trailing three years as of November 30, and US high-yield bonds returned 10%. These strong returns were driven by high starting yields and a significant narrowing in credit spreads—down 52 bps for investment-grade and 179 bps for high-yield. The tightening in spreads, a pattern that was evidenced across most regions and instruments, was justified by robust economic and earnings growth, resilient corporate fundamentals, and subdued issuance, but yields are now less compelling, and spreads are historically tight across public credit.

While spreads could drift lower in the near term, upside for public credit is limited and downside risks have increased. The environment is more fragile, with slowing growth and emerging stress in the labor market and among low-income consumers and select corporate borrowers, highlighted by recent high-profile defaults. Riskier assets look increasingly vulnerable after the sharp run-up in equity valuations, as discussed earlier in this outlook, and the potential for slower growth and elevated costs could pressure corporate earnings and margins. Although material spread widening is not our base case, the credit cycle is maturing and risks favor wider spreads, supporting an underweight stance in public corporate credit within core fixed income.

Despite expensive public credit markets, select spread products offer compelling relative value. We favor US agency mortgage-backed securities (MBS)—particularly higher-yielding current coupons—and US municipal bonds (munis). We believe current coupon MBS are higher quality and well positioned to outperform if spreads widen, providing defense without sacrificing yield. Notably, current coupons (4.9%) now yield more than corporates (4.8%). Historically, at these levels, current coupons have outperformed corporates 62% of the time over the next two years, with returns ranging from -3% to 11% per year. Their spreads, unlike corporates, remain above historical lows with room to tighten as rate volatility subsides. Although rate volatility has declined since its recent peak, it remains somewhat elevated. With quantitative tightening ending and further modest rate cuts likely once tariff-related inflation pressures ease, there is scope for both volatility and MBS spreads to compress further, supporting returns.

Munis also offer attractive relative yields for taxable investors. For high-tax-bracket US families, munis have consistently delivered stronger after-tax returns than Treasury bonds and corporates. After adjusting for taxes, the yield advantage for munis is unusually wide—currently about 185 bps versus Treasury bonds and 93 bps versus corporates, among the widest taxable-equivalent spreads since the Global Financial Crisis, excluding isolated stress periods. Many taxable investors reduced muni holdings over the past decade, favoring Treasury bonds or, in some cases, even reaching for yield in credit, as low yields limited their tax advantage and valuations were less compelling. That is no longer the case, and the current environment favors shifting back toward munis at the margin.

Against this backdrop, it is important to recognize that public credit markets overall offer limited upside and heightened downside risk as spreads remain tight and the economic outlook softens. In this environment, we recommend a defensive posture within core fixed income, emphasizing higher-quality, more resilient sectors, with attractive relative value. US current coupon agency MBS and municipal bonds stand out for their relative yield advantage and diversification benefits. For those investors for whom these investments are appropriate, focusing on them may help position portfolios for more balanced risk-adjusted returns in 2026.

Investors should lean into private asset-based finance strategies in 2026

by Wade O’Brien

In 2026, credit investors face challenges such as expensive valuations, moderating growth and falling yields. Recent bankruptcies like First Brands and Tricolor also highlight the risk of weaker underwriting in at least some segments. We believe the solution is focusing on less correlated private credit strategies such as asset-based finance (ABF), insurance-linked securities, and litigation funding. Some of these strategies can be accessed via semi-liquid vehicles, freeing up illiquidity budgets for other parts of the portfolio.

Less correlated private credit strategies are attractive relative to expensive public credit assets. Strong demand has pushed spreads on assets like US high-yield and investment-grade bonds near the bottom decile of historical data, as we discuss elsewhere in this outlook. While demand across products is likely to be underpinned by yields near historical medians, returns are vulnerable if the pace of expected Fed cuts disappoints.

ABF funds offer investors the ability to diversify portfolios away from cyclical and expensive corporate lending. These funds lend against a variety of assets including consumer loans, real estate, and equipment leases. Underlying loans are less economically sensitive and have shorter maturities, allowing lenders to reprice them more quickly as conditions change. Accelerated cash return can also help investors concerned about slower distributions in other parts of their private portfolios. Recent bankruptcies have drawn attention to the ABF market, but were idiosyncratic, given the fraud and business practices involved. Still, they highlight the importance of careful manager selection, as both cases involved red flags that were ignored by markets. Fundraising by dedicated ABF funds has picked up but remains a fraction of the volumes seen in other private credit strategies.

While direct lending funds are currently less attractive in our view than less correlated private credit strategies, they remain attractive relative to comparable public credits. Fed rate cuts and lower spreads will impact returns, but fundamentals have been stable and defaults limited. The biggest near-term challenge for direct lending funds is competition from both the syndicated loan market and retail-targeted vehicles. Semi-liquid retail funds, including private business development corporations (BDCs) and interval funds, had accrued around $350 billion in assets by year-end 2024, a 60% increase in just two years. Reduced buyout volumes have cut supply and added to pressure on spreads, but resurgent M&A activity as rates decline and tariff uncertainty clears may help. Lower middle market lending funds, which offer higher spreads and better protections for lenders, are preferred to upper middle market.

Investors can access direct lending and ABF via open-ended vehicles as well as traditional closed-end funds. Private BDCs and interval funds may charge higher fees but offer investors the ability to more frequently adjust exposures. Investors that can access lower fee institutional evergreen funds may find them an attractive substitute for liquid credit assets featuring low spreads and yields.

Other private credit strategies—such as royalties, litigation finance, and insurance-linked securities—also have appeal. They tend to have resilient income streams insulated from the economic cycle and less sensitive to corporate fundamentals. Returns for these strategies have compared favorably with other types of private credit in recent years. These markets require highly specialized expertise, making their return streams less vulnerable to rising competition or surging demand from retail-targeted offerings.

In summary, with public credit markets offering limited value and increased competition, investors should look to private credit—especially ABF and specialized strategies—for better diversification, resilience, and risk-adjusted returns in 2026.

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Recent headlines have drawn attention to the bankruptcies of First Brands and Tricolor, raising investor concerns about credit quality and fraud risk. Jamie Dimon, CEO of JPMorgan Chase, captured market sentiment by warning, “When you see one cockroach, there are probably more,” which fueled speculation about hidden vulnerabilities in credit markets. The private credit market has grown rapidly, attracting increased scrutiny as the credit cycle matures. These high-profile defaults have prompted questions about whether these events are isolated or indicative of broader risks, particularly in private credit markets, which are inherently more opaque than public markets.

In our view, both First Brands and Tricolor failed due to company-specific frauds rather than broader macroeconomic challenges or poor lending practices indicative of systemic issues. Tricolor operated in a high-risk segment, focusing on subprime auto lending—often to undocumented borrowers—and is alleged to have double-pledged loans across multiple credit lines. First Brands was an aggressive acquirer in the aftermarket auto parts industry, relying heavily on off-balance sheet financing that was poorly disclosed to investors. The company was also accused of double-pledging assets in its supply chain and inventory finance arrangements. Supply chain finance has historically been susceptible to fraud, given the high velocity of relatively small transactions. The fact that both frauds have come to light in a short time frame may reflect late-cycle dynamics, but ultimately they are unrelated events resulting from the actions of a few bad actors.

Importantly, the First Brands and Tricolor frauds were not unique to private credit; they affected a range of investment vehicles, including public asset-backed securities (ABS), broadly syndicated loans (BSL), and large bank warehouse lines. Traditional credit market participants—banks, auditors, and ratings agencies—were exposed and failed to detect the frauds. For example, JPMorgan is facing significant losses from Tricolor, and many collateralized loan obligations (CLOs) are facing losses from First Brands’ BSL. In contrast, most high-quality private credit managers identified warning signs early—such as abnormally high margins, opaque off-balance sheet financings, and management credibility—and largely avoided both situations. The ability of private credit managers to conduct deep, ongoing diligence and maintain close relationships with borrowers provided a clear advantage in risk detection and avoidance. Strong alignment of lenders and the ability to properly conduct due diligence is more important than the specific market segment (public or private) when it comes to avoiding fraud and credit losses.

Private credit markets continue to show solid fundamentals. The Federal Reserve has been cutting interest rates and is expected to make three additional 25-basis point reductions by the end of 2026, which will reduce interest expense for middle-market companies and help alleviate cash flow pressures. According to Kroll Bond Rating Agency (KBRA), the weighted-average interest coverage ratio across middle market loans was 2.3 at the end of third quarter 2025, up from 2.0 a year ago. While loan documentation has weakened in middle-market direct lending—particularly in the upper-middle market segment—the sector has not seen widespread use of liability management exercises (LMEs) that have become common in the BSL market. As a result, default rates in the middle market are expected to remain lower than in the BSL market. As of October 2025, KBRA is forecasting a default rate by volume of 1.5% for the direct lending market in 2025, down from 1.8% in 2024. For comparison, this year’s BSL market default rate may reach 3.8%.

Looking ahead, we believe private credit continues to offer attractive risk-adjusted returns and diversification benefits. In particular, we favor commitments to asset-based finance (ABF) funds in 2026 due to the higher barriers to entry and generally stronger lender protections associated with these strategies. However, as the recent frauds have demonstrated, ABF’s additional complexity is both an opportunity and a risk, requiring more robust due diligence.

The post Do the Recent Bankruptcies of First Brands and Tricolor Suggest Trouble Ahead in Private Credit? appeared first on Cambridge Associates.

Investment Implications Through The Tech Cycle

To navigate the AI investment landscape, it is helpful to segment the market into five archetypes that capture the diverse ways in which companies interact with AI:

1. Creators are the pioneers at the frontier of AI innovation—companies developing foundational models, advanced algorithms, the software development toolchain, and specialized hardware that form the core of the technology.
2. Disruptors create a transformative change that goes beyond integrating technology into an existing process, launching new business models that were unimaginable prior to the technological leap (e.g., Uber or Amazon of the internet era).
3. Enablers provide the essential physical infrastructure that makes AI possible, including semiconductors, data centers, and energy solutions.
4. Adaptors are businesses that integrate AI into their operations, harnessing its power to drive efficiency, unlock new business models, expand their market share, and maintain competitive advantage.
5. Finally, the Disrupted are incumbents whose market share or relevance is threatened by the rise of AI-powered competitors.

Each of these archetypes presents distinct investment opportunities and risks across asset classes.

As discussed in Part 1, where we highlighted past technology cycles, this framework echoes the dynamics of the internet era that launched the information age. During that period, Apple, Google, and Microsoft were among the creators, building the platforms and software that defined the new economy. Amazon emerged as a disrupter, fundamentally changing the retail landscape. With the emergence of cloud computing, software-defined infrastructure was developed to manage or enable compute, storage, and networking through software. Companies like Intel and Cisco served as enablers, providing the chips and networking equipment that powered the digital revolution. Today, as AI ushers in another wave of transformation, understanding where companies sit within this cycle is essential for identifying both risks and opportunities across the investment landscape.

Creators and Disruptors

Venture capital (VC) remains a crucial funding source for innovative start-ups engaged in high-risk research and product development. This dynamic drove previous technology waves, such as the internet, mobile, and cloud computing. However, the AI era presents a different landscape. Unlike the cloud era—where established companies were slow to adapt and start-ups captured early gains—many incumbents are now early AI leaders. These companies are cloud-native and deeply integrated into corporate systems. They leverage their scale and distribution to build AI capabilities internally or accelerate innovation by acquiring or investing in VC-backed AI start-ups. Notable examples include Google’s acquisition of DeepMind (which powered Google Brain and Gemini), Microsoft’s early partnership with OpenAI, and Amazon’s partnership with Anthropic. Hyperscalers’ capital expenditures have been extraordinary and are expected to continue as AI technology advances. Key areas of VC investment include large language models (LLMs), supporting software infrastructure, and “applied AI” applications built on this foundation.

As outlined in Part 2, VC investment in AI has reached record highs, with intense enthusiasm and abundant capital pursuing a limited number of high-quality start-ups. Adoption rates have surged across many companies (see Part 1), but much of the early revenue is “experimental,” reflecting trial phases rather than sustainable businesses. This momentum has spurred a wave of new company formations and AI strategy announcements, creating significant “AI noise” in the market. Interest is also growing in “physical AI,” where AI intersects with industries such as manufacturing, construction, healthcare, and aerospace and defense. However, all this frenzy has led to inflated valuations, intense competition, and overfunded segments given its relative infancy. Although AI-first companies have seen rapid revenue growth, its durability is uncertain due to the experimental nature of adoption and the lack of strong competitive moats—even companies with $50 million–$100 million in revenue can be overtaken whereas in prior cycles that typically signaled victory. While a few leaders have already created significant value, many AI start-ups are likely to fail due to oversaturation, poor management, and rapid sector evolution.

Historically, major technology shifts often result in commoditization, and it is rarely clear at the onset which companies will ultimately succeed. The winners are typically those that either build on existing technology through innovation or leapfrog older products and services entirely. For instance, Dell Technologies initially dominated the PC market, EMC led in on-premises enterprise data storage before the transition to cloud solutions, and Cisco was the leader in network hardware before the rise of software-defined networking. AI is likely to follow similar patterns, with rapid change and innovation making it difficult to identify long-term leaders. As open-source competition and verticalized alternatives have driven SaaS commoditization, so too will these forces and the broader open-source community drive further innovation and disruption in AI. Despite these uncertainties, we expect long-term VC returns in AI to remain attractive.

Who will be the winning investors? We recommend diversifying across the AI value chain and managing risks through careful position sizing. Investors should prioritize general partners (GPs) with deep sector expertise, particularly at the foundational and network infrastructure levels, and a proven track record of business building. This expertise—whether within specialist or generalist firms—enables better deal flow, talent identification, and assessment of technical merit. Select specialists for investments where technology risk is high, and generalists for broader investment strategies, leveraging the strengths of both. As AI becomes more widespread and many start-ups incorporate it into their products, investment decisions will increasingly focus on how AI is applied rather than on the technology itself. This trend mirrors previous technology cycles, where, as markets matured, investment success depended more on careful selection and curation than on technical expertise. Many GPs focused on AI are relatively new and still gaining investment experience, given the technology’s rapid rise in prominence. Large generalist firms have captured many early AI successes, often partnering with specialists to combine strengths. These generalists offer larger capital pools, enabling them to support AI start-ups through multiple funding rounds, provide customer access, and offer business-building expertise. Their broad go-to-market and business development capabilities help start-ups as they scale.

Enablers

Enablers are the backbone of the AI revolution, providing the physical infrastructure that supports AI’s rapid expansion. The primary beneficiaries to date have been semiconductor manufacturers (especially those producing AI chips), hyperscale data center operators, and the power and utility companies that support this ecosystem. However, the scale and speed of investment in these areas have raised concerns about sustainability, valuations, and the risk of overbuilding—reminiscent of the internet era’s fiber optic boom and bust.

The rise of generative AI and LLMs has driven unprecedented demand for high-performance chips, particularly GPUs and custom AI accelerators. Companies like Nvidia, AMD, and emerging players such as Cerebras have seen orders and backlogs soar. Supply constraints and technological leadership have enabled leading chipmakers to command premium pricing and margins. Dominant players, especially Nvidia (through its CUDA platform), are building integrated hardware-software ecosystems, creating high switching costs and network effects, but also raising antitrust concerns. Valuations remain high, with Nvidia trading at a forward price-to-earnings (P/E) ratio of 32.3, as of June 30, 2025. While this is below 2024 peaks, it remains vulnerable to correction if AI adoption slows, or competition intensifies. As such, consider modest tilts away from expensive public equity mega-cap tech stocks to reduce valuation risk and enhance portfolio diversification.

Data centers are also major beneficiaries, driven by AI, ongoing cloud adoption, and rising data usage. McKinsey estimates data center capacity demand will grow at an annual rate of about 20% through 2030, with generative AI data centers accounting for a small, but growing share of new demand. Investors should partner with infrastructure and real estate managers with specialized development and operating expertise that are well-positioned to benefit from this supply/demand imbalance. However, transaction multiples have risen materially, averaging 25x EBITDA over the last four years according to Infralogic, compared to a 13.5x average for private infrastructure more broadly. This makes careful underwriting essential for attractive returns. Like other AI infrastructure assets, data centers face risk of overbuilding, as well as regulatory and environmental concerns and constraints such as local opposition and permitting delays. These risks can be mitigated by focusing on managers who can develop assets at lower multiples (e.g., low double-digit EBITDA) and sell into a strong market, often with long-term contracts from investment-grade hyperscalers (e.g., Microsoft, Amazon) seeking development partners. In contrast, speculative and remotely located data centers with more limited utility face heightened risks. From a portfolio construction perspective, data centers offer lower expected returns than private investments in innovative AI firms but can provide returns competitive with broad equities (e.g., 15%–20% target gross IRR) with diversification benefits.

Other enablers, such as utilities and grid infrastructure, have also seen increased demand and capital inflows driven by electrification and digitization trends. McKinsey expects global data center capacity demand between 2025 and 2030 to drive investment in power (including generation and transmission) to total between $200 billion (constrained momentum) to $600 billion dollars (accelerated demand), with $300 billion as their baseline for continued momentum. US on-grid electricity demand is expected to increase 2%–3% per year through 2030 up from virtually flat growth over the last decade, with faster growth in Asia (from a lower base) and slower growth in Europe. While difficult to estimate, rapid AI adoption and potential onshoring in the United States could further boost energy demand. Although AI energy efficiency is expected to improve, associated cost reductions may spur broader adoption, likely resulting in net energy demand growth. Investment in essential electricity infrastructure with inelastic demand is critical. Data centers require reliable power, necessitating redundant infrastructure such as back-up generators and batteries.

All enabler segments have strong growth potential, with chips and data centers experiencing the fastest expansion, but they also trade at heightened valuations and have the greatest exposure to overbuilding. Scale, technological edge, strong customer relationships, and specialized expertise are critical for managing these risks.

Adaptors and the Disrupted

Building on the productivity themes from Part 2, growth equity and private equity-backed companies are increasingly using AI to boost revenue and improve margins. As private entities, they have more flexibility to integrate and scale AI across operations, though successful implementation requires careful execution. While many companies are still experimenting, some are already seeing early benefits in product enhancements and margin gains.

Private equity investors are actively assessing both the opportunities and risks AI brings to their portfolio companies and industries. They look for cost savings through automation (e.g., customer support, onboarding, coding) and revenue growth from AI-driven products (e.g., sales planning, demand forecasting). At the same time, they remain cautious about risks, such as commoditization (e.g., graphic design, digital marketing) and increased competition from low-cost automation (e.g., auditing, document preparation, call centers). Technology-focused managers have an edge due to sector expertise, but both specialist and generalist firms are hiring AI talent to support investment teams and portfolios. The full impact of AI will unfold over time as new use cases and broader adoption and understanding of AI technologies and their impact continue to emerge.

Similarly, public companies must adapt to AI or risk disruption. Investors should focus on active management to distinguish winners from losers and to assess price risk, selecting managers with deep sector expertise. Employ long/short and fundamental strategies to manage risk and exploit valuation dislocations. Public investors face the challenge of avoiding overvalued AI leaders while not overlooking lower-priced companies that may lag behind. Many leading public companies are cloud-native and well-positioned for AI, but investors should consider the entire spectrum of innovators and disruptors. Public market valuations for AI-enabled companies have dropped from their late 2021 peak; forward P/E ratios relative to the S&P 500 Index hit a nine-year low earlier this year, and have since rebounded, but remain below recent historical spikes. This environment favors long/short managers that can identify mispriced companies amid the current AI hype.

As outlined in Part 1, we recognize that non-technological factors—particularly regulatory and policy uncertainty—are increasingly shaping both the AI investment landscape and broader societal outcomes. The concept of Responsible AI (RAI) is gaining more attention as generative AI models and systems grow in complexity and become more deeply embedded across industries. RAI frameworks address the development and deployment of LLMs and broader AI applications, emphasizing principles such as fairness, transparency and explainability, accountability, privacy, safety, and security. From an investment perspective, effective governance is inherently complex, intersecting regulatory, ethical, technological, and human considerations. This complexity necessitates cross-disciplinary collaboration and often involves navigating trade-offs and misaligned incentives. As AI adoption accelerates, reported incidents of ethical misuse have increased in recent years. A recent survey found that only 14% of businesses have dedicated AI governance roles, yet 42% reported improved operations and 34% noted increased customer trust due to RAI policies and investments. ¹ Companies should proactively assess, and address financially material risks associated with neglecting RAI practices, such as regulatory actions or erosion of their societal license to operate, which could result in negative commercial consequences. Governments worldwide are trying to address complex issues like data privacy, algorithmic transparency, antitrust, and national security, and new regulations could significantly impact sector competition. Investors must also monitor regulatory developments closely, as evolving rules and policies will likely influence long-term value creation and competitive differentiation in the rapidly evolving AI sector.

The “AI noise” phenomenon extends beyond private investments. Most technology companies now market themselves as AI-focused, and those that do not, risk appearing outdated. Enterprise software incumbents with high switching costs, complex technology, and strong innovation pipelines may continue to thrive, while agile start-ups can exploit weaknesses and expand from niche solutions into strategic adjacencies, potentially displacing incumbents. For example, it is unclear whether established security firms will lead in AI security or whether nimble start-ups will secure the AI/ML software supply chain. ServiceNow, a leading enterprise software provider, has thus far demonstrated successful AI adoption by leveraging its integrated suite and existing customer base to pivot toward AI-driven solutions. Given the rapid pace of change, both long-only and long/short hedge funds can find alpha by capitalizing on short-term disruptions and mispriced companies. Valuation-based and fundamental short strategies remain relevant, though it can be difficult to short declining businesses that retain temporary relevance or to identify companies prematurely dismissed as AI losers. Investors should consider managers with crossover expertise—spanning both public and private markets—as they are well-positioned to capitalize on rapidly evolving AI developments by spotting trends in private markets before they are reflected in public market valuations, and can continue to invest post IPO.

AI-related risks and opportunities are increasingly influencing credit markets. Credit managers are financing core infrastructure—such as GPUs, data centers, and energy projects—while also supporting the broader AI ecosystem. Several large managers are establishing dedicated asset-backed finance teams and raising capital specifically to pursue these opportunities. Direct lenders, in particular, have significant exposure to technology and business services, which will need to adapt in response to AI advancements.

More broadly, credit managers must evaluate the adaptability of their portfolio holdings. Many software companies—particularly those with high leverage and business models vulnerable to AI automation (e.g., HR, legal, accounting, and other back-office SaaS providers)—face considerable disruption risk. The past decade’s low-rate environment led to aggressive leverage and high valuations, leaving some companies with thin interest coverage and little margin for error. These firms are especially vulnerable if AI-driven disruption erodes their revenue base. Should AI agents automate or disintermediate core functions, revenue models may be cannibalized, and even modest declines in topline revenue could threaten debt service capacity.

Some credit managers are proactively encouraging portfolio companies to adopt AI, aiming to drive efficiencies and mitigate disruption risk. Lenders are increasingly evaluating management’s AI strategy as part of their underwriting process. Companies that successfully integrate AI may improve margins and creditworthiness, while laggards risk being left behind. As disruption accelerates, a wave of distressed opportunities may emerge among over-levered incumbents unable to adapt to AI-driven change. However, the timing of this transition is highly uncertain: some companies may be “slow melting ice cubes,” experiencing gradual market decline, while others may yet adapt successfully.

Investors should select credit managers who proactively assess AI-related opportunities and risks, including overbuilding in data centers and other infrastructure, while proactively managing exposure to incumbents in sectors vulnerable to AI disruption, such as highly leveraged back-office SaaS providers. Credit opportunity managers may be best positioned to benefit from distressed cycles arising from AI-driven disruption, as these managers can capitalize on market dislocations.

Investors should question managers on their approach to AI, both in terms of portfolio company adaptation and exposure to AI-related risks and opportunities, as part of ongoing due diligence.

Conclusion

AI is fundamentally reshaping the investment landscape, presenting both extraordinary opportunities and new risks across asset classes. The technology’s reach extends from the innovators building core capabilities, to the enablers providing critical infrastructure, to the adaptors and disrupted incumbents navigating a rapidly changing environment. Although substantial investment has already driven rapid growth in AI and its supporting infrastructure, we remain in the early stages of this technological shift, which is expected to evolve over the next decade and beyond. In previous technology cycles, the initial investments and returns from foundational innovation were ultimately surpassed by the gains generated by disruptive companies. These disruptors leverage the established or rebuilt technology infrastructure and benefit from network effects as commercial adoption accelerates, enabling them to redefine industries or create entirely new markets and business models. Attractively valued companies that can leverage AI to improve their profitability should also benefit meaningfully.

Investors should strategically seek opportunities to incorporate AI Creators, Disruptors, Enablers, and Adaptors within their portfolios, all the while maintaining a careful watch on potential disruption risks and the possibility of inflated valuations and overbuilding. Investment success in this new era will require investors to combine deep sector expertise, rigorous due diligence, and a willingness to adapt as the technology and its applications evolve. Investors that partner with managers that can distinguish between hype and enduring value, anticipate regulatory shifts, and identify the true drivers of sustainable growth will be best positioned to capture the far-reaching potential of AI in shaping asset allocation for years to come.

Grayson Kirk, Graham Landrith, and Archie Levis also contributed to this publication.

Footnotes

1. Nestor Maslej, Loredana Fattorini, Raymond Perrault, Yolanda Gil, Vanessa Parli, Njenga Kariuki, Emily Capstick, Anka Reuel, Erik Brynjolfsson, John Etchemendy, Katrina Ligett, Terah Lyons, James Manyika, Juan Carlos Niebles, Yoav Shoham, Russell Wald, Tobi Walsh, Armin Hamrah, Lapo Santarlasci, Julia Betts Lotufo, Alexandra Rome, Andrew Shi, Sukrut Oak. “The AI Index 2025 Annual Report,” AI Index Steering Committee, Institute for Human-Centered AI, Stanford University, Stanford, CA, April 2025 and McKinsey & Company survey 2024.

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Heading into 2025, historically low spreads on some higher-yielding credit instruments meant investors were not well positioned for recent tariff-related turbulence. At the end of 2024, the option-adjusted spread (OAS) on US HY bonds stood at 287 basis points (bps), in the bottom decile of historical observations. As a result, while the backup in spreads in recent weeks felt dramatic, it still leaves the current OAS (409 bps) below its historical median. A similar trend is evident in loans. The discount margin on BB-rated loans has widened by approximately 40 bps in 2025, but the current 297-bp spread is only around the 45th percentile of historical observations.

Investors considering increasing allocations to these assets should recognize spreads could go significantly higher if the economy enters recession. While the Global Financial Crisis may be an extreme level for comparison (HY spreads reached nearly 2,000 bps), during the past three recessions HY spreads averaged around 800 bps, around double today’s level. Another consideration is whether current pricing suggests HY bonds can keep pace with a comparable stock/bond mix. Our data suggest that buying HY bonds around current spreads (in the second quartile) has often resulted in underperformance relative to a stock/bond mix. Conversely, HY bonds have typically outperformed when spreads rise to the top quartile (around 585 bps or higher). Investors may be better off waiting for spreads to reach these higher levels before increasing allocations.

While the macro environment remains uncertain, there are positive arguments to be made in favor of US HY bonds and loans. Entering what may be a period of subdued growth, many HY issuers are in a position of relative strength. Rising revenue and earnings have allowed companies to gradually deleverage in recent years, and metrics like interest coverage ratios have shown steady improvement. Notably, today’s HY index consists of higher-quality borrowers than historically has been the case, which could provide a buffer if conditions worsen. Currently, ~53% of the HY index carries at least one BB rating, an 8 percentage point increase from a decade ago.

HY bonds and loans may also benefit from investors attracted to their higher coupons. The current HY bond index yield of 8.4% is around 170 bps above its average over the past decade. While broadly syndicated loan yields—currently around 9.0%—may also look enticing, we caution that this reflects lower average credit quality. Additionally, these instruments may see coupons decline if, as expected, the Federal Reserve resumes its rate-cutting cycle in 2025.

Given the uncertainty surrounding tariff-related volatility and concerns over foreign demand for US assets, investors should hold off on adding HY and loan exposure. Also, certain pockets within liquid credit already appear more attractive. One example is CLO mezzanine debt, which currently offers a discount margin of around 775 bps (equivalent to around a 11.5% yield). Historically, this asset class has suffered lower defaults than comparably rated HY bonds, though its lower liquidity can result in higher mark-to-market volatility. Due to the dispersion in underlying CLO fundamentals, we believe this asset class is best accessed via skilled managers.

In summary, HY bonds and loans have sold off in recent weeks, but from historically expensive levels. We recommend waiting for further clarity on the macro outlook or further pricing improvements before adding exposure to assets like HY bonds and loans. When conditions improve, investors contemplating adding to credit allocations should also consider CLO debt, which is currently more reasonably priced but may still face spread widening if tariff-related volatility escalates. Meanwhile, investors should maintain allocations to high-quality sovereign bonds, which should continue to provide critical portfolio diversification and stability amid ongoing macro uncertainty.

Footnotes

1. Nestor Maslej, Loredana Fattorini, Raymond Perrault, Yolanda Gil, Vanessa Parli, Njenga Kariuki, Emily Capstick, Anka Reuel, Erik Brynjolfsson, John Etchemendy, Katrina Ligett, Terah Lyons, James Manyika, Juan Carlos Niebles, Yoav Shoham, Russell Wald, Tobi Walsh, Armin Hamrah, Lapo Santarlasci, Julia Betts Lotufo, Alexandra Rome, Andrew Shi, Sukrut Oak. “The AI Index 2025 Annual Report,” AI Index Steering Committee, Institute for Human-Centered AI, Stanford University, Stanford, CA, April 2025 and McKinsey & Company survey 2024.

The post Should Investors Add to High-Yielding Credit Allocations, Given the Recent Rise in Spreads? appeared first on Cambridge Associates.

Specialty finance investments can be additive to a private credit portfolio. This asset class helps to diversify away from corporate lending to individual businesses and is broadly uncorrelated with equity markets. As a world within a world, specialty finance offers a wide range of underlying asset types and potential return targets. It allows investors to tailor the potential liquidity and duration when selecting a fund.

The Growth of Specialty Finance and Role of Alternative Credit Investors

As the amount of assets committed to private credit has grown, renewed attention is being paid to specialty finance. Prior to the 2007–09 Global Financial Crisis (GFC), the specialty finance market was a smaller, less prominent segment of the financial market. Traditional banks dominated lending activities, and non-bank financial institutions (NBFIs) played a relatively minor role. Specialty finance funds, meanwhile, have stepped in to address the financing needs of these NBFIs, resulting in nearly 10x growth in assets of these types of funds since the throws of the GFC (Figure 1) from $28.0 billion in 2008 to $275.8 billion in 2023.

Various factors have contributed to specialty finance’s growth, including tighter bank regulations and stricter capital requirements following the GFC. These rules in part came out of the Dodd-Frank legislation in the United States and the Basel III frameworks established as part of the Basel Accords in Europe. Banks incur risk-based capital charges against the specialty finance lending they do, which has direct impacts on the profitability of certain business lines. The onerous nature of this capital treatment has curtailed lending by banks, and in the cases where banks do engage in these activities, it has typically been with the most pristine businesses with proven track records, leaving newer or more complex borrowers with limited options to obtain financing.

This gap in the demand for borrowing and the supply of financing from banks has been addressed by the specialty finance market, which itself seeks non-traditional sources of financing. Private credit firms focused on the specialty finance space have demonstrated a willingness and ability to work with complex or underbanked segments of the market. These underbanked parts of the market are expected to grow as banks face further strain, including regulatory capital needs. In the United States especially—depending on regulatory approval—the application of the Basel III “endgame” would drive growth in this area. To get in front of this potential supply, specialty finance investors have in many cases been expanding their direct relationships with borrowers, including regional and community banks in the United States.

For US taxable investors in general, we expect that the returns from specialty finance funds to be characterized as ordinary income, and many have commensurate (and sometimes onerous) tax implications. For that reason, these investments might be more suited to non-taxable entities in the United States and non-US entities with friendly tax treatments.

Opportunities, Risks, and Advice for Investors in Specialty Finance

Specialty finance investing offers the potential for compelling risk-adjusted returns. Attractive characteristics of these investments are 1) the cash flowing nature of the underlying assets and 2) the downside protection often created through structuring. There is potential in the current market for higher investment returns from both higher base rates and wider spreads to compensate for the complexity of the assets or their structures.

Non-bank lenders, shadow banks, and financial technology (fintech) businesses have developed in recent years to address a varied set of opportunities.

Consumer and Small Business Lending

One area targeting finance companies in particular is lending against a pool of financial assets. The underlying loans can be made to consumers or small businesses, and this business of lending to lenders is sometimes called re-discount lending. This area has seen growth with the rise of fintech businesses, which help to streamline application, credit selection, and funding processes for consumer and small business financing.

A hallmark of this type of investing is the ring fencing of risk—to protect the collateral from the risk of bankruptcy at the loan originator, the specialty finance manager will lend against a pool of assets that is kept in a separate, bankruptcy-remote special purpose vehicle (SPV). In the event that there were problems with the borrower, the lending specialty finance fund can simply stop funding new loans or other financial assets, thereby stopping the creation of new risks while servicing and running down the book of business in the SPV. It is possible for the loan originator to file for bankruptcy and the specialty finance fund manager to take no losses as 1) the manager, not the loan originator, is exposed to the pool of assets, thereby allowing the pool to be transferred and serviced elsewhere; 2) the existing pool of loans might have been amortizing and reducing the fund’s cost basis; and 3) the existing pool of credits might still have the ability to repay their principal and possibly interest.

Expected returns can vary depending on the credit quality of the underlying investments as well as the seniority of the tranche retained by the fund. Benefits of such funds include diversification away from individual credit risks, as the portfolios tend to include pools of loans or other financial assets. Potential investors should be sure to understand the nature of the underlying assets and beware a concentration of risk in any single risk factor.

Asset and Equipment Leasing

Asset and equipment leasing involves the ownership of a pool of assets, such as transportation assets (e.g., railcars, aircraft engines, shipping containers), yellow metal equipment (i.e., construction and agricultural equipment), or restaurant equipment. As in a fixed income investment, the investor collects cash flows, but they are often in the form of lease payments tied to contracts on the assets and equipment. There is also opportunity to provide financing to companies looking to purchase such equipment.

Expected returns can vary based on the structure and duration of the leases offered as well as the growth stage of the lessee. Investors should take note of the expertise of the specialty finance manager as it pertains to 1) the assets being leased or financed and 2) the ability to structure customized leases that take into account the needs of the lessee.

Litigation Finance

Litigation finance is where investors fund plaintiffs or law firms to cover legal costs, receiving a portion of any monetary settlement if the case is successful. Expected returns are attractive, with internal rates of return (IRRs) for some strategies exceeding 20% and 1.5x multiples on invested capital at the portfolio level. However, individual cases have binary outcomes, with either full recovery or total loss of capital.

Aside from the potential for attractive returns, given the uncorrelated nature of case outcomes to traditional capital markets, investors can achieve diversification benefits for their portfolio. Additionally, there is a positive social aspect to consider, as litigation finance often enables access to justice for those who might not afford it otherwise. However, investors should be aware of potential regulatory changes, adverse selection by law firms, and duration risk. Targeting experienced, institutional-quality managers is recommended.

For those preferring a less binary risk-return profile, managers providing loans to law firms or investing in specialized opportunities may offer more downside protection, while still providing attractive risk-adjusted and uncorrelated returns.

Insurance-Linked Securities

Insurance-linked securities (ILS) are financial instruments where investors take on risk from insured natural catastrophes (e.g., hurricanes and earthquakes) and man-made events (i.e., marine, energy, and cyber incidents). They provide interest income from insurance premiums and principal repayment if no material financial loss occurs. Common types include catastrophe bonds, industry loss warranties, collateralized reinsurance, and collateralized retrocession.

Most ILS are exposed to a narrow definition of natural catastrophe risk: loss due to residential property damage caused by natural disasters. Therefore, diversification is the main attraction of investing in ILS, as the returns of the asset class are uncorrelated to traditional capital markets. Additional highlights of ILS include access to specialized insurance markets, capital efficiency, the potential for attractive risk-adjusted returns, and inflation protection due to their floating-rate nature.

However, portfolio implementation and benchmarking can be challenging. Careful manager selection is crucial, considering factors such as capital reserving techniques and climate change approaches. Investors should be mindful of market cycles and potential headline risks, and a long-term commitment is recommended.

Royalties (Life Sciences and Music)

Royalties in life sciences and music offer exposure to revenue streams from intellectual property. In life sciences, royalties come from pharmaceutical products, medical devices, and biotechnology innovations, paid to original developers or patent holders based on sales or usage. In music, royalties are earned from musical compositions, recordings, and performances, paid to songwriters, artists, and producers whenever their work is played, streamed, or sold.

Benefits of investing in royalty strategies include diversification (returns are uncorrelated to traditional financial assets), steady income streams (royalties provide a consistent and often predictable income stream, as they are tied to the ongoing sales or usage of the underlying intellectual property), and the asset class is often viewed as an inflation hedge, as payments typically increase with the rising cost of goods and services.

Considerations of the asset class include potential regulatory changes (particularly in life sciences) that could impact returns, market demand as the value of royalties is highly dependent on the continued demand for the underlying product or work, intellectual property disputes, and the illiquid nature of royalties.

In some cases, there is a need to assess both loan originators and underlying customers. An investment manager pursuing such investments must underwrite the underwriter and analyze the credit box/profile to which they lend. This analysis on occasion requires expertise in some narrow areas in the market whether that is understanding the mechanics of mass tort lawsuits or having the relationships with lessors of transportation assets and structuring appropriate leasing deals. Look for specialty finance managers with platforms that offer advantages in sourcing investments. While each case is unique, these advantages might be conferred through the breadth of the origination team, the quality of borrower relationships and repeat nature of business, as well as exclusivity or flow arrangements with fintech companies.

Concluding Thoughts

With specialty finance funds, we can generally expect IRRs in a range of mid-single-digit percentages to high-teen percentages, with the difference in returns being a function of use of leverage, age of the borrower, and tenor of the deals. In addition, there is an unknowable element at play in cases, such as litigation finance that might rely on juries’ decisions (Figure 2). A review of specialty finance funds across vintages in the Cambridge Associates database revealed a mean IRR of 11.8%. ²

Specialty finance investing has added layers of complexity relative to other forms of private credit investing. As such, these investments are typically not a core investment in a private credit allocation but rather a satellite or complement to core direct lending exposure. The funds tend to be in typical private equity fund structures in which capital is committed and drawn down across various vintages. In those cases, the funds have investment periods ranging from two years to four years and fund lives of six years to ten years, although the full term of many funds tends to reside in the six- to eight-year zone. Even within these fund lives, many of the transactions are shorter duration in nature relative to private equity deals, for example. As such there is room for recycling of capital during the investment period, which can help drive the fund’s multiple on invested capital. However, the evergreen fund structure has become more popular in recent years, offering limited partners (LPs) flexibility with respect to continuing to invest as well as timing of monetizations and exits.

While the return streams of specialty finance investments often maintain low correlation to general credit and equity indexes, there is the potential for market volatility to impact these investments. Interest rate changes, for example, can have impacts on the cost of financing for the borrowers but also for specialty finance lenders. In some cases, market volatility can impact the value of the underlying pools of assets in these transactions, which has ripple effects on the loan-to-value (LTV) metrics monitored and provide guardrails around risk taking for some specialty finance investors.

Investing in specialty finance funds with their varied sources of returns can help to diversify your portfolio while preserving capital and should help create more stability of cash flows. In this way, specialty finance investing can provide an effective complement to a broad private credit allocation.

Footnotes

1. Nestor Maslej, Loredana Fattorini, Raymond Perrault, Yolanda Gil, Vanessa Parli, Njenga Kariuki, Emily Capstick, Anka Reuel, Erik Brynjolfsson, John Etchemendy, Katrina Ligett, Terah Lyons, James Manyika, Juan Carlos Niebles, Yoav Shoham, Russell Wald, Tobi Walsh, Armin Hamrah, Lapo Santarlasci, Julia Betts Lotufo, Alexandra Rome, Andrew Shi, Sukrut Oak. “The AI Index 2025 Annual Report,” AI Index Steering Committee, Institute for Human-Centered AI, Stanford University, Stanford, CA, April 2025 and McKinsey & Company survey 2024.
2. Past performance is not a reliable indicator of future results. All financial investments involve risk. Depending on the type of investment, losses can be unlimited.

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Liquid Credit Returns Should Be Lower in 2025

Wade O’Brien, Managing Director, Capital Markets Research

Following solid gains in 2024, US liquid credit returns will be lower in 2025, given lower credit spreads and expected Fed easing. The flipside is that credit fundamentals remain sound and there are pockets where investors can find attractive risk-adjusted returns.

US high-yield bonds returned roughly 9% year-to-date through November 30 and US investment-grade credit bonds generated around 4%. Returns were boosted by falling credit spreads; through November 30 US high-yield and investment-grade index spreads had fallen by 58 bps and 21 bps, respectively. The decline in Treasury yields further benefited returns, with respective yields at 7.14% and 5.05%.

Even if investors in 2025 receive coupon-like returns, this would still be higher than recent averages, given the low interest rate environment that prevailed prior to the pandemic. For example, the ten-year AACR on US high-yield bonds was just 5.1% as of November 30. Returns next year could receive a lift if spreads compress further or if the Fed cuts rates faster than expected, though we would note spreads look expensive on a historical basis and in recent weeks the amount of expected Fed easing in 2025 has been pared back.

Either way, returns should be supported by improving fundamentals. Earnings growth was inflecting upward for both high-yield and investment-grade borrowers as 2024 drew to a close, and borrowers with floating rate debt should continue to see interest coverage ratios improve given falling short-term rates.

Looking across liquid credit markets, we are neutral between fixed and floating rate. Additional rate cuts could boost values for the former, but the latter will serve as a hedge against inflationary pressures. Across all types of liquid credit, we do not think it is an opportune time to stretch for yields, as spreads for most assets are in the bottom quartile, or even decile, of historical readings. While being mindful of duration, collateralized loan obligation debt offers a spread pickup with little give up in terms of credit quality or liquidity.

Insurance-Linked Securities Should Deliver Attractive Returns in 2025

Joseph Tolen, Senior Investment Director, Credit Investments

The insurance-linked securities (ILS) market continues to be attractive and should deliver strong returns in 2025. The demand for additional catastrophe coverage from insurance companies has kept the market firm, providing sufficient cushion for reinsurers and ILS managers to absorb risk. This is evidenced by managers achieving impressive returns in both 2023 and 2024 despite a notable rise in severe storms in the US Midwest, multiple significant hurricanes making landfall, and flooding in Europe. The sustained hard insurance market, combined with the uncorrelated nature and diversification benefits of investing in ILS, make 2025 an attractive opportunity for investors.

Several factors have supported the insurance market, which has improved ILS pricing and resulted in more favorable terms and conditions for investors. Premium increases following Hurricane Ian and balance sheet losses on the back of a particularly challenging year for traditional assets in 2022 created a capital shortage for reinsurers, limiting their ability to provide coverage for insurance companies. Conversely, demand for protection from insurance companies has sharply increased due to high rates of inflation in recent years and the need for broader coverage, largely related to climate change.

The supply/demand imbalance is set to continue into 2025. Additional supply will be available from reinsurers and ILS managers following two strong years of performance, but this is expected to be offset by continued demand for coverage from insurance companies, particularly on the back of hurricanes Helene and Milton. These factors will keep the insurance market firm, leading to more attractive pricing for investors and giving them additional cushion to absorb losses, even if 2025 sees higher-than-average catastrophe events.

When considering opportunities, terms and conditions will be crucial to performance success. We favor managers that are meticulous in portfolio construction and appropriately invest in line with their stated risk/return profiles regarding attachment points and where they sit in the capital stack, perils, trigger mechanisms, geographies, and so on. Doing so will help mitigate exposure to risks associated with climate change, put investors in the best position to absorb losses from events, and help maximize returns.

Currencies Should Become a Tailwind for Emerging Markets Local Bonds in 2025

Thomas O’Mahony, Senior Investment Director, Capital Markets Research

The currency component of EM local currency bond performance has frequently been the dominant driver of the asset class. This is perhaps unsurprising when one considers it has exhibited nearly twice the volatility of the local currency performance. In four out of the past five calendar years, including 2024, the currency return has been a detractor from the total return for a USD-based investor, which is of course explained to a large extent by the strong performance of the dollar over this time period. While the currency return may not exceed the fixed income return in 2025, we think it is likely to cease being a headwind and ultimately become a tailwind.

The J.P. Morgan GBI-EM Global Diversified Index currently yields 6.30%. This is at the 34th percentile of its history, so in terms of return drivers, it looks as though the carry of the index will be somewhat below average in 2025. Despite this more moderate yield, there is still scope for the index to deliver some price appreciation next year. Inflation in emerging markets has remained contained after the post-COVID spike. Therefore, with real yields still somewhat elevated, there is scope for EM central banks to ease rates should growth conditions necessitate. Further, if DM bonds yields decline, EM bonds yields, which typically trade with a beta to those of developed markets, should also move somewhat lower.

Our EMD-weighted currency index has declined in recent months, now sitting 14% below its median real valuation versus the dollar. We anticipate this valuation gap will narrow somewhat next year. First, from the USD perspective, the currency remains richly valued against substantially all peers. Though we remain sensitive to the risk of further dollar appreciation given, in particular, the spectre of tariffs being placed on trade with the US, we expect the dollar to eventually weaken as the Fed continues to ease policy, narrowing interest rate differentials. Furthermore, the growth differential between emerging and developed markets looks set to widen as we move into 2025, which may support the risk appetite for EM assets. Any additional policy easing from China would reinforce such a dynamic. Naturally, there are risks to this view, such as a material slowdown in global growth or a pickup in global inflation. However, our expectations are for a more favorable environment for EM currencies in 2025.

Direct Lending Returns Should Decline in 2025

Wade O’Brien, Managing Director, Capital Markets Research

Direct lending funds are on track to generate strong returns in 2024, returning 9% year-to-date through September 30. Returns should decline in 2025 as central banks continue cutting benchmark rates and competition among lenders lowers credit spreads. Still, spreads will remain above those available in public credit, and rising deal volumes will create more opportunity for investors to put capital to work.

Benchmark yields have moved lower after the Fed’s recent rate cuts and are expected to continue declining over the course of 2025. Direct lending spreads are also falling and are now around SOFR+ 525 compared to around 370 bps for broadly syndicated loans (BSLs). Spreads should continue to decline in 2025, given competition from the BSL market for larger deals and as direct lending funds are eager to deploy more than $250 billion in dry powder.

There is some good news for investors. Credit fundamentals, which have been under pressure for some borrowers, should improve in 2025 as rates decline. This will be especially helpful for smaller firms, which have seen slower revenue growth than larger peers. Default rates on private loans should start to recede as debt servicing ability improves.

Deal volumes have picked up in recent quarters and this trend should continue in 2025. Low interest rates are improving deal economics for PE sponsors, which in some cases are under pressure from investors to deploy capital. Greater supply could serve to offset some of the downward pressure on spreads from growing competition among lenders.

Weighing these dynamics, investors in private lending funds should continue to earn higher returns in 2025 than available from public equivalents and should see more capital put to work. Lower middle-market funds may suffer from less spread compression than large peers, which tend to face competition from BSLs, though investors should carefully screen managers as not all small companies will see fundamentals improve.

Liability Management Transactions Should Accelerate in 2025

Frank Fama, Head of Global Credit Investment Group

With the Fed transitioning to a rate-cutting cycle and inflation trending to target, recession fears have largely abated. However, with the dearth of M&A activity and weak IPO market, PE sponsors are finding it difficult to exit investments. Sponsors are faced with an aging portfolio and a number of problems. Many of these leveraged buyouts (LBOs) were financed in the broadly syndicated loan market in 2021 before the rate increase cycle and after the disruption of COVID-19. Lenders agreed to provide high leverage due to elevated valuations and low interest rates, and credit protection provisions were extremely weak. Now PE sponsors have overleveraged companies with maturing debt in need of a recapitalization solution and companies in need of growth capital to take advantage of attractive opportunities.

Credit opportunities managers will work with sponsors to take advantage of the excesses of the BSL market to structure investments that may prime existing lenders and lend new money at mid-teens rates. Known as liability management, the transactions can take different forms, but they all take advantage of provisions in the credit agreement that allow for the creation of new debt, to the detriment of existing lenders. Skilled managers are able to accumulate a position at a discount and structure and lead a transaction that results in at par or near par recovery for their debt and create a new debt security that is senior and secured by the most valuable collateral. Executing the strategy well requires active management and strong industry relationships. At first, sponsors viewed the transactions as excessively aggressive, but they are coming to view the solution as effective in managing their stressed LBOs and activity is expected to accelerate in 2025.

PE managers are holding investments longer, which is creating pressure to continue supporting companies, either because the company has too much debt or the company needs growth capital. Credit opportunities managers will partner with PE managers to take advantage of weak creditor protections in loan documents to provide capital that is senior and at higher yields relative to the existing BSL lenders.

US Specialty Finance Transaction Volumes Should Increase in 2025

Adam Perez, Managing Director, Credit Investments

With US consumer non-housing debt at nearly $5 trillion and growing, the opportunity set for specialty finance managers to fund non-bank lenders is expanding. In addition, specialty finance funds are poised to engage in larger significant risk transfer (SRT) transactions with banks, driven by the need for banks to align their balance sheets with the Basel III Endgame requirements. These factors will increase US specialty finance deal volumes in 2025.

Declining policy rates and avoiding a global recession in 2025 should entice US consumer borrowing further next year. As traditional banks face regulatory constraints and capital requirements, non-bank lenders are stepping in to fill the gap. This shift is creating a robust pipeline of investment opportunities for specialty finance funds, which can provide the necessary capital to these non-bank entities and benefit from a sustained demand for alternative lending transactions.

Moreover, the Basel III Endgame, the latest set of rules from the Basel Committee on Banking Supervision, which aims to fortify the management of risk within the banking sector, is pushing banks to offload riskier assets from their balance sheets. Like specialty finance lending, SRT is another element in the trend of reduction in bank balance sheet risk. This regulatory environment is conducive to the growth of SRT transactions, a mechanism whereby a third party agrees to assume certain credit risks from a bank, deleveraging the bank’s balance sheet and thus providing the bank with regulatory relief. US bank regulator proposals for alignment with the Basel III Endgame portend higher capital charges and are an important factor contributing to the growth of these deals in the United States. In addition, our expectation that policy rates will fall will likely reduce net interest margins, putting further pressure on banks as they seek profitability to right size balance sheets through SRTs. As banks strive to align with these rules, SRT deal volume will increase in 2025.

Figure Notes

Spreads Look Expensive for Many Credit Assets
Asset classes represented by: Bloomberg US Corporate Investment Grade Bond Index (US IG), Bloomberg Pan-European Aggregate Corporate Bond Index (Euro IG), J.P. Morgan CLOIE BBB Index (CLO BBB), J.P. Morgan CLOIE BB Index (CLO BB), Bloomberg US Corporate High Yield Bond Index (US HY), Bloomberg Pan-European High Yield Index (Euro HY), and Credit Suisse Leveraged Loan Index (US LL). Observation periods begin June 30, 1989, for US IG, January 31, 1992, for US LL, January 31, 1994, for US HY, August 31, 2000, for Euro HY & Euro IG, and December 31, 2011, for CLO BBB & CLO BB.

Demand for Coverage at All-Time Highs, Evidenced by Catastrophe Bonds Outstanding
Data for 2024 are through November 30.

Direct Lending Spreads Have Steadily Declined
Three-month rolling averages for first lien term loans. Spreads are to the Secured Overnight Financing Rate (SOFR). EBITDA $100M+ data begin September 30, 2021.

Default Rates Remain Low, But Distressed Exchanges (Including Liability Management Transactions) Have Been Increasing
The Default Rate is calculated by dividing the number of issuers that defaulted in the last 12 months by the total number of issuers.

Footnotes

1. Nestor Maslej, Loredana Fattorini, Raymond Perrault, Yolanda Gil, Vanessa Parli, Njenga Kariuki, Emily Capstick, Anka Reuel, Erik Brynjolfsson, John Etchemendy, Katrina Ligett, Terah Lyons, James Manyika, Juan Carlos Niebles, Yoav Shoham, Russell Wald, Tobi Walsh, Armin Hamrah, Lapo Santarlasci, Julia Betts Lotufo, Alexandra Rome, Andrew Shi, Sukrut Oak. “The AI Index 2025 Annual Report,” AI Index Steering Committee, Institute for Human-Centered AI, Stanford University, Stanford, CA, April 2025 and McKinsey & Company survey 2024.
2. Past performance is not a reliable indicator of future results. All financial investments involve risk. Depending on the type of investment, losses can be unlimited.

The post 2025 Outlook: Credit Markets appeared first on Cambridge Associates.

Aaron Costello, Regional Head for Asia, and Vivian Gan, Associate Investment Director, Capital Markets Research

With the global economy showing signs of cooling and Chinese economic momentum remaining weak, the outlook for Asian markets is increasingly mixed. Certain markets have been more resilient, such as India, where domestic growth is still robust, and Taiwan, which has benefitted from the global rally in semiconductor and artificial intelligence (AI)–related stocks. However, elevated valuations in these segments pose a concern for investors, prompting a reassessment of opportunities elsewhere. In the current environment, a rotation towards markets that may be more defensive and where shifts in market dynamics are supportive of longer-term prospects is warranted. In this edition of Asia Insights, we highlight:

• Within Asia Public Equities, there is a growing emphasis on shareholder returns and a rise in the number of companies increasing dividend payouts and initiating share buybacks. This trend comes amid a market rotation towards high dividend–yielding companies, as investors seek stable income returns given rising uncertainty and overvaluations in certain segments of the market.
• In Asia Private Credit, capital has rotated away from China and towards developed markets such as Australia and South Korea, while India also remains a destination for capital. Broadly, the Asia private credit market remains underpenetrated and is less crowded but poised for growth, presenting an interesting opportunity for investors to gain a diversified exposure.
• India Venture Capital (VC) is also starting to look more attractive today given a favourable macroeconomic backdrop, an improving start-up and manager landscapes, and a broadening of exit channels. In contrast to India public markets, which have run up and appear frothy, India VC activity has cooled alongside global VC markets. As a result, India VC valuations are moderating, making now a more opportune time for investors considering access.
• Across China Private Investments, fundraising activity remains frozen given uncertainty over geopolitical tensions and pending US investment restrictions. However, deal-level opportunities still exist in certain segments of the market, particularly for buyouts where the current macro environment is conducive for market consolidation and control opportunities.

Asian Public Equities: A New Era for Shareholder Returns

Wilson Chen, Managing Director, Public Equities

In Asia, we have seen an increased emphasis on shareholder returns and a notable rise in the number of companies initiating share buybacks and increasing dividend payouts. Japan, driven by regulatory changes and increased shareholder activism, has led this shift. Reforms introduced by the Tokyo Stock Exchange in January 2023 have put pressure on Japanese companies that trade below book value to take action to narrow their valuation discount, largely through increasing dividends and conducting shares repurchases. Such measures have helped to boost Japanese companies’ return-on-equity and supported upward stock price revaluations, creating positive tailwinds for the market. The small-cap segment could see greater benefits from reforms, given wider valuation discounts.

In South Korea and China, similar efforts are now being observed. South Korea’s ‘Corporate Value-up Program’ seeks to improve capital efficiency and equity valuations of firms through the voluntary disclosure of plans to enhance shareholder value. In China, more firms are responding to regulatory calls to increase dividends and share buybacks and others are re-listing on more favourable exchanges or spinning off units to unlock value and boost investor confidence.

From a total return perspective, dividends have always played a crucial role, although their importance has been magnified in markets such as China, which has seen weaker earnings growth and depressed valuation multiples. In the current environment, investors have rewarded companies able to generate high, stable income returns, a rotation that is reflected in the performance of the MSCI AC Asia ex Japan High Dividend Yield Index, which has outperformed its parent index by 4.2 percentage points (ppts) year-to-date and 9.4 ppts over the trailing one year. The trend of increased emphasis on shareholder returns in Asia is positive for investors and may also be a more defensive strategy given rising uncertainty and overvaluations in certain segments of the market, such as semiconductors and AI-related stocks.

Asia Private Credit: Growing Momentum for Asia ex China Strategies

Vijay Padmanabhan, Managing Director, Credit Investments

Private credit in Asia (including Japan and Australia) remains an underpenetrated market relative to the size of the region’s economy and demand for capital. Private credit and other forms of non-bank credit represent approximately 20% of the total Asia credit market, as compared to 65% in North America. Meanwhile, fundraising by Asia-based private credit funds amounted to just 5% of total capital raised by global private credit funds in the trailing five years ending 2023.

Fundraising activity slowed sharply in 2023, with lacklustre activity in part due to ongoing weakness in China’s property market. Many pan-Asian general partners had been overweight China prior to its real estate crisis, and the performance of these strategies, as well as that of dedicated China funds, has continued to struggle since.

Outside of China, however, the opportunity set remains robust. Managers are increasingly pivoting to developed Asia markets such as Australia and South Korea, which are credit-friendly jurisdictions in which banks are retrenching and high-quality collateral is available. The presence of higher sponsor activity in these markets creates space for sponsor-backed lending opportunities, while credit opportunities in sectors such as real estate are also rising given a trend of tightening liquidity from traditional lenders. Across emerging Asia, India is a bright spot for managers given its resilient economic growth outlook and improving credit regulations and credit landscape. India private credit had predominantly leaned towards distressed credit due to its legacy non-performing asset challenges and, more recently, in the aftermath of its NBFC (non-bank financial company) liquidity crisis. However, the strategies have since broadened to include performing credits in the underserved, midmarket segment, and solution capital to businesses for share buybacks and growth or acquisition financing.

Lower penetration and competition today create a compelling environment for Asia private credit strategies, as these allow for deals to be executed at better terms, pricing, and covenants. Overall, the market is poised for growth and presents an interesting opportunity for investors seeking to gain a diversified exposure across both developed and emerging Asian credit markets.

India Private Investments: The Growing Attractiveness of India Venture Capital

Vish Ramaswami, Head of Asia-Pacific Private Investments and Sharad Todi, Senior Investment Director, Private Equity

Amid a mixed economic outlook for Asia, India has stood out for its resilient economic growth. As a result, India public equity markets have run up and appear frothy, making some investors cautious about entering the market. In contrast, India’s VC market is cooling in terms of fundraising and deal activity alongside a shakeout in global VC markets, and valuations have moderated, particularly for later-stage VC. Given India’s long-term growth potential and favourable government policies, today may be a more attractive entry point for India VC in our view.

Dedicated India VC fundraising totaled only $1.8B in 2023, down sharply from more than $10B in 2022, and remains small compared to total global VC fundraising at $201B. Yet, India VC is benefitting from an improving start-up landscape in terms of the quality of founders, business models, and technology. The Indian government has spearheaded the creation of a digital public infrastructure or ‘India stack’, which has been widely adopted by start-ups to create disruptive new business models and tools. Consumer focused start-ups have moved away from cash-guzzling business models and towards profitable, sustainable growth. Enterprise technology start-ups are setting global standards in sectors such as software-as-a-service and financial technology.

Meanwhile, the manager pool has matured significantly. Progressing from a generalist mindset, managers are taking distinct market positions and have developed capabilities beyond simply sourcing deals to enhancing value and risk management. While India VC fund distributions have lagged their global counterparts, this may improve going forward as India’s capital markets broaden. In addition to initial public offerings, new exit routes are emerging, including merger & acquisitions deals and sales to financial sponsors and large family offices.

India VC also provides a different sector exposure compared to Indian public markets, which may be more reflective of the future growth drivers of the Indian economy. Given a cooling of the market, now may be a better time for investors to refresh their assessment of India VC for potential opportunities to gain access.

Chinese Private Investments: Frozen Fundraising, but Deal-Level Opportunities Remain

Vish Ramaswami, Head of Asia-Pacific Private Investments, Scolet Ma, Senior Investment Director, Private Equity, and Linlin Zeng, Investment Director, Private Equity

Fundraising for Chinese private equity and venture capital (PE/VC) slowed further in first half 2024 from the already depressed levels seen in 2023. Total capital raised by USD-denominated Chinese PE/VC funds fell to $1.0 billion in first half 2024, down from $16.9 billion in 2023 and $30.1 billion in 2022. Muted levels of fundraising largely reflect uncertainty over geopolitical tensions and pending US investment restrictions on China, although investor sentiments have also been buffeted by a weaker outlook for China’s economic growth and public markets.

Slowing economic momentum and a poor environment for exits have also weighed on VC and growth equity deal activity and exits, particularly for sectors, such as semiconductors and AI, that are subject to pending US investment restrictions. However, pockets of opportunity remain. Healthcare and biotech, for instance, have seen continued foreign investor activity even in the face of the proposed US BIOSECURE Act ³ .  A rise in the development of innovative drugs and devices from China has spurred an increase in out-licensing activities and acquisitions by global pharmaceutical companies. Across other sectors, opportunities are similarly present, particularly given some recent downward valuation adjustments. Limited partners that possess a longer investment horizon (i.e., beyond a typical PE/VC fund life of ten years) and have the patience and ability to tolerate uncertainty may be able to take on certain co-investments to capitalize on current attractive valuations.

Meanwhile, Chinese buyout activity picked up in first half 2024, with 19 deals completed as compared to 31 in all of 2023. The current macro environment bodes well for market consolidation and control opportunities. Weaker economic growth in China has created more willing sellers across both domestic founders, as well as multinationals looking to divest from China. Valuation gaps between buyers and sellers have narrowed, and lower borrowing costs in China imply availability of leverage. Although the Chinese buyout market remains less proven, the current environment is favourable in supporting the building out of such strategies.

Derek Yam also contributed to this publication.

Footnotes

1. Nestor Maslej, Loredana Fattorini, Raymond Perrault, Yolanda Gil, Vanessa Parli, Njenga Kariuki, Emily Capstick, Anka Reuel, Erik Brynjolfsson, John Etchemendy, Katrina Ligett, Terah Lyons, James Manyika, Juan Carlos Niebles, Yoav Shoham, Russell Wald, Tobi Walsh, Armin Hamrah, Lapo Santarlasci, Julia Betts Lotufo, Alexandra Rome, Andrew Shi, Sukrut Oak. “The AI Index 2025 Annual Report,” AI Index Steering Committee, Institute for Human-Centered AI, Stanford University, Stanford, CA, April 2025 and McKinsey & Company survey 2024.
2. Past performance is not a reliable indicator of future results. All financial investments involve risk. Depending on the type of investment, losses can be unlimited.
3. The pending US BIOSECURE Act identifies five Chinese biotech companies that would be prohibited from obtaining US government contracts or deriving revenue from US companies and agencies that receive US government funding. The proposed guidelines do not impose restrictions on US PE/VC investments into Chinese biotech.

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