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You might have noticed, but we love bloody credit here at Alphaville. We’re also partial to a good visual metaphor, and Allianz’s chief investment officer has come up with a good one related to the US credit complex.
Last week, the German insurance company published a report written by Ludovic Subran and team, titled: Credit risk relocated, not removed: Newton’s cradle transmitting risk across BBB, HY, and private credit. The main argument is that the corporate debt market is shakier than it might seem:
• US credit looks calm on the surface – spreads tight, headline growth cheerful — but the risk has simply migrated. Investment grade (IG), high yield (HY) and private credit are one continuous risk-transfer chain and at every link price has decoupled from fundamentals through a different mechanism: spread compression in IG, weakest links bypassing public HY and net asset value (NAV) smoothing in private credit.
Why? Aren’t investment-grade bonds super-strong at the moment?
• Softened IG fundamentals and fallen-angel risk expose up to 1/3 of spread. US IG spreads sit at ~75bps – tighter than their pre Iran-war level – even as credit quality has softened (interest coverage ~6.3x, net leverage ~2.7x), held tight by price-insensitive all-in yield demand rather than by fundamentals. The specific danger sits at the bottom of IG: a fallen-angel downgrade forces index-constrained holders to sell into a smaller, less liquid HY market, producing spread moves that far exceed the change in credit quality. In stress case like 2020, downgrades eroded 25bps of excess return, which would be equivalent to ~1/3 of current spread. The net upgrade rate has run below zero for roughly three years and actual fallen angels are ticking up, with historically tight spreads leaving no cushion to absorb the loss.
What about high-yield bonds (or junk bonds, depending on your preferred nomenclature)?
• HY offers a more defensive risk/reward profile than BBB – but largely due to a composition effect, as the weakest names have migrated out to private credit. HY leverage (~3.8x) and coverage (~2.8x) have held firmer than a deteriorating BBB, helped by shorter duration (3yr vs 7yr for IG) and a cleaner index (BB now >50%, CCC near a 20-year low). But much of that strength is a composition effect: the weakest borrowers have migrated out to leveraged loans and private credit. The risk was not removed – it was relocated.
So where did it relocate? Aaah, private credit, obviously.
• The same decoupling runs quietly underneath private credit, via NAV smoothing. The migrated borrowers are structurally weaker (leverage 5 –7x, coverage 1 –2x), and because positions are appraisal-valued, NAVs stay smooth while coverage erodes. Stress therefore surfaces not in price but in the plumbing: Payment-In-Kind has roughly doubled to 8.9% of interest income from a 4.3% trough in early 2023, and lender takeovers reached USD39.4bn across 2025 –26 – about three times the prior three years combined, though still low single digits against a ~USD1.75trn book. The fallen-angel analog here is a gate or restructuring, not a downgrade – lumpy and deferred – concentrated in software/AI -exposed names (~25% of portfolios) and the 2021 –23 vintage.
OK, that might be lot to digest. Let’s unpick it a little, without the block quotes.
It basically boils down to Allianz arguing that potential corporate debt stress is being obscured by different technical factors, and that stresses in one market can easily travel to neighbouring ones — much like how pressure waves can travel through the seemingly stationary balls of a Newton’s Cradle.
High-grade corporate bonds are trading at exceptionally high prices, low yields and tight spreads over comparable US Treasury bonds, despite their creditworthiness actually weakening lately. That’s simply because there’s so much demand for even the slender yield pick-up you get, and investors aren’t now adequately compensated for the risks of downgrades.
High-yield bonds have also performed well lately, but mostly because the sketchiest companies have headed to the leveraged loan and private credit markets. As a result, over half the market is now rated BB, the highest non-investment-grade rung, and only 10 per cent has a junky CCC rating, the lowest in 20 years. At the same time, the average maturity is now only three years, further insulating the market from trouble.
In private credit, problems are masked by a more periodic and . . . artisanal approach to valuations. What pressures there are can be further obscured by turning a potentially dud loan into a “payment-in-kind” note, where interest payments simply get deferred and rolled into the principal, putting off any reckoning.
The problem is that this is all a little precarious. Allianz, unfortunately, doesn’t actually fully explore the Newton’s Cradle metaphor of its title — ie that risks can swing to, through and from all corners of credit — but it does think high yield is in particular much more vulnerable than the fundamentals might imply:
. . . . Under market stress, the risk that left public HY could return to it. Crowded private-credit and HY-overweight positions cannot be exited quickly. So when investors need to de-risk, they tend to sell the most liquid public HY first, regardless of its own fundamentals, and its spreads widen. In that sense, the near-term risk in public HY is more a liquidity and basis effect than a credit-quality one. Spreads can move beyond what the improved composition would justify – simply because HY is the proxy being sold for positions that cannot be.
In other words, junk bonds may in fact be less junky than they used to be, on average. But if the credit cycle does break bad then that might not do it much good, because its likely to become the “involuntary shock absorber” for private credit, Allianz argues. Which doesn’t sound like much fun?
