For several years, simply having exposure to corporate credit was enough. Macro factors and beta did much of the heavy lifting, helping drive both total and excess returns across large parts of the market. But that environment is beginning to change.
Headline spreads still look relatively contained and, on the surface, credit markets appear reasonably calm. But underneath, the market is becoming far more differentiated.
Corporate credit investors are increasingly rewarded for bottom-up work and the ability to move across issuers, sectors and ratings, rather than simply deciding how much credit exposure to hold overall.
A key driver is rising dispersion of performance amongst bond issuers: the gap between issuers that can sustain balance-sheet strength and those facing operating margin pressure, refinancing risk of existing debt or adverse company specific events, is widening.
Even when aggregate bond index spreads look range-bound, relative-value opportunities between different bond issuers are increasing across sectors, rating buckets and capital structures – creating a larger payoff to being right on ‘which credits to own’ rather than merely ‘how much credit to own’.
Dispersion on the rise
One reason dispersion is rising is that idiosyncratic risk has become more decisive in shaping excess returns. Idiosyncratic risk, measured by the number of bonds with significant price movements not explained by beta, remains consistently elevated compared to 2021, suggesting that single-name drivers continue to impact spreads even when they are tight.
Corporate balance sheets are no longer being normalised by uniformly easy financing conditions; instead, outcomes are becoming increasingly company specific. AI-related disruption, shifting demand preferences, elevated real borrowing costs and debt-funded M&A activity are all contributing to wider divergence between winners and losers.
In this environment, avoiding weaker credits can matter just as much as identifying attractive sources of carry. A relatively small number of underperforming issuers can drive a disproportionate share of portfolio drawdowns, particularly when spread levels leave less room for error.
The rapid development of AI is also beginning to reshape competitive dynamics across industries. Some companies are emerging as clear beneficiaries. Others face growing questions around the durability of their business models and long-term cashflow resilience.
Why active management matters
These conditions also expose the limits of passive corporate bond exposure for those that chose to closely follow traditional bond market indices. Market-cap-weighted indices track the volume of bond issuance and systematically allocate more to the largest debt issuers, which are often the most levered.
As a result, sector concentrations tend to reflect bond issuance patterns rather than forward-looking fundamentals of the underlying issuers.
That becomes more problematic when valuations are tight and broad beta moves become less dominant. Passive exposure can unintentionally create concentration in deteriorating credits precisely when selectively matter most.
Active investors, by contrast, have greater flexibility to move across sectors, ratings and issuers as fundamentals evolve. In a market increasingly driven by company-specific outcomes rather than broad market direction, that flexibility becomes far more valuable.
Fundamentals matter
Importantly, the case for selectivity does not require a bearish macroeconomic view. Many large, public issuers entered this phase with extended maturity profiles, relatively healthy interest coverage and manageable leverage, helping support overall market resilience even as financing conditions remain restrictive by recent historic standards. At the same time, divergence within credit markets is becoming more pronounced.
While default rates in broadly syndicated bond markets have shown signs of stabilising, stress within certain private credit segments continues to rise. The result is a market where aggregate spread levels can appear stable even as underlying borrower fundamentals increasingly diverge.
In that environment, carry can still remain an attractive source of return, even as dispersion increases beneath the surface. But returns are likely to depend less on broad market exposure and more for identifying the businesses, balance sheets and management teams capable of navigating a more demanding environment.
George Bory is chief investment strategist at Allspring. The views expressed above should not be taken as investment advice.