Credit Cracks: Signals Beneath the Surface

We recently sat down with Dominic Nolan, CEO of Aristotle Pacific Capital, to get his analysis of credit markets, the likelihood of further rate cuts, and opportunities in fixed income. We conclude with a speed round of questions and answers, and a personal reflection.

Market Performance

October was another strong month for stocks and bonds. What happened?

We are seeing a concentrated growth rally in equities. The S&P 500 Index rose 2.3% in October and is up 17.5% for the year, while the S&P 500 Equal Weight Index declined 1% last month and is up about half as much, 8.9%, for the year. The Russell 1000 Growth Index outperformed both, returning 3.6% in October and 21.5% for the year.

Meanwhile, bond market returns hovered around coupon rates. The Bloomberg US Aggregate Bond Index rose 0.6% in October and is up 6.8% for the year. Investment-grade corporates led credit sectors again in October, returning 0.4%, while high-yield corporates and bank loans both returned about 0.2%. For the year, those sectors are up 7.3%, and 4.9%, respectively.

Bottom line: Markets are continuing to experience a healthy year with a favorable economic backdrop. Corporate earnings reflect this, with per-share-profit growth trending above 10% for S&P 500 companies. In addition, the Federal Reserve (Fed) has resumed easing, and I think there's hope for trade progress with China.

Mag 7 +  Broadcom

What was notable about the Magnificent 7?

Most of the Mag 7 – and Broadcom, which we chose to add to the seven – performed well in October, while Microsoft was essentially flat and Meta declined 11.7% for the month, though it’s still up for the year. Investors are reacting to Meta’s guidance that capital expenditures (capex) will be “notably larger” in 2026 versus 2025.  For context, the company recently sold $30 billion of bonds, the largest high-grade US note sale since 2023, to help fund AI infrastructure development, and said its capex would be around $72 billion  this year.  Meta’s revenue was $165 billion in 2024 , and while it likely will be higher this year and next year, it’s a monstrous commitment to have capex be in the ballpark of half a company’s revenue.

One final observation is that Nvidia’s stock has returned more than 50% this year, as of the end of October, and its market capitalization has approached $5 trillion, which is even more incredible when one considers it was $4 trillion just a few months ago.

U.S. Treasury Yield Curve

U.S. Treasury yields fell at the front and back end of the curve in October. What drove the move?

The Fed exerts direct control over the very front-end of the curve and only influences the long end. As of the end of October, the curve was downward slopping up to about two years to maturity, then flat, and then upward slopping from about three years to about 20 years, when it flattened again. The downward trajectory of the front end reflects investor anticipation of further rate cuts. In the middle of the curve, where the Fed begins to influence more than control, bonds were yielding about 3.6% at the end of October and a bit further out at the 10-year maturity the yield was a little above 4%, where it has been for months. Indeed, overall rates were close to flat in October, and the belly of the curve is normalizing as the Fed cuts rates. There is greater uncertainty around the long end of the curve. On days the Fed has cut rates, long-term yields have risen. Still, overall yields remain range bound.

Fed Futures

The Federal Open Market Committee (FOMC) cut the fed funds rate by 25 basis points in October and announced quantitative tightening (QT) will end on December 1^st. Which of the two announcements is more impactful, and where do we go from here?

I think the QT shift has greater implications, since it’s new and should help lower long-term rates. Of course, both policy moves matter. While the FOMC has been lowering rates since 2024, the federal funds rate remains elevated at the current 3.75% to 4.00% range. Investors expect the Fed to cut about three more times over the next eight months or so, bringing the target range to 3.00% to 3.25%, and thus short-term rates would normalize around 3%. Naturally, this could all change if inflation or unemployment shift unexpectedly.

Economic Dashboard

What are your observations on the economy?

We see mixed signals in the data available. Signs of a strong economy include the Atlanta Fed’s GDPNow model recently pegging third quarter growth at 4%. Also, as discussed here and in previous interviews, tech companies continue to aggressively build and power data centers, with aggressive tax depreciation incentives aligning this behavior. The robust capex acts as a near-term economic boost but is pulling investment forward. Meanwhile, the Consumer Price Index hit 3% in September on an annual basis and was close to that level in previous months, which is another sign of a healthy economy but a potential constraint on Fed cuts.

However, the employment data is signaling a softening economy. The Bureau of Labor Statistics recently said it had overestimated hiring for the 12 months ending in March by more than 900,000 jobs.

Consumer spending, as measured by credit card data tracked by Bank of America, has risen by only 1% over the past 12 months, with big swings in categories. Consumers spent more on transit, electronics, and online retail purchases, while they decreased spending on home improvement and entertainment. I see those shifts as reflecting workers returning to the office and consumers making fewer discretionary purchases.

Government Shutdown Continues

Do you expect the government shutdown to have an economic impact?

Mostly, I believe it is non-political nonsense, and as taxpayers it should bother us. However, there are some ramifications. While one might expect the shutdown to be a drag on economic growth that motivates the Fed to cut rates, the opposite appears to be true for the Fed in the near term. Fed Chair Jerome Powell has said if the shutdown delays the release of economic data, the central bank might have to delay action on rates rather than guess at the state of the economy. Also, in addition to federal employees furloughed or working without pay, the shutdown is directly affecting air travel. If it continues into the holidays, many more people are likely to see travel disruptions.

Loan Defaults Now Outpace Bond Defaults

Let’s turn to our special topic. The sudden demise of First Brands and Tricolor in September has sparked debate about whether those bankruptcies were one-off events or are indicative of broader credit cracks. To begin our analysis, what is occurring with defaults, and what does it mean?

A comparison of defaults on high yield bonds and leveraged loans can be a useful starting point. From 2015 to 2020, mostly before the pandemic became a serious concern in the U.S., high yield bond defaults averaged 3.1%, while loan defaults averaged 2.2%. Post COVID, the relationship has flipped, with leveraged loan defaults averaging 2.6% since 2021, and high yield bonds 1.9%. Also, we have seen high yield bonds trending up in credit quality, while leverage loans have been trending down.

So, what’s driving all this? In private credit, which has been booming, most of the lending is done via leveraged loans, also known as bank loans or floating-rate loans due to their variable interest rates. With the insatiable demand to lend via private credit, loan covenants have been diluted. Also, since the Fed has not cut rates as much as anticipated, front-end costs are elevated. Together these factors have pushed leveraged loan defaults above high yield bond defaults. Another data point to incorporate is that downgrades are outpacing upgrades, which is typically a sign of a weakening credit cycle.

Ten Largest Defaults/Distressed Transactions YTD

How do distressed exchanges fit into this picture, and how are they different from payment defaults?

We have been seeing substantial activity in distressed exchanges this year and understanding them is worthwhile. A payment default is straightforward: A borrower misses payment and is in default. Several things can happen in that event, including the creditor assuming ownership, working out a payment plan, or liquidating assets. However, prior to missing payment a borrower could approach a lender and request a distressed exchange, such as reducing the debt in exchange for equity, or the borrower might receive relief via a lower interest rate or extended maturity. While this behavior avoid a classic default, it usually results in a haircut to the lenders.  

Saks Global Enterprises, parent of Saks Fifth Avenue and Neiman Marcus, is a case study of gradual forbearance. Taken private a few years ago, Saks is in a secularly declining business and has worked out refinancing deals in recent months with holders of its nearly $2.2 billion in bonds,  in one of the largest distressed exchanges this year. Compare that to the sudden bankruptcy of auto-parts company First Brands. Press reports have cited billions of dollars of off-balance-sheet debt that were not flagged by its auditor.  It also raises questions about the amount of diligence done by lenders to First Brands.

Same Outcome - Two Different Paths

Business Development Companies are Signaling Credit Challenges

How do business development companies (BDC) relate to the credit cracks you are seeing?

BDCs are closed-end funds that invest in small- to medium-sized companies, but unlike venture capital firms, BDCs are publicly traded and distribute 90% of their income to shareholders. For much of this year, the S&P 500 Index and the S&P BDC Index were highly correlated. But starting around July they started to diverge, and the BDC Index was down more than 8% for the year up to October 20. This is a signal of potential credit weakness among smaller firms.

PIK Usage Dispersion Growing

One more acronym: What’s up with PIKs?

Admittedly, we are covering a lot of credit terms, but together they hint at a bigger picture. Payment in kind (PIK) occurs when a borrower doesn’t make a cash interest payment and that unpaid amount is added to the loan balance, essentially creating a negatively amortizing loan. The borrow gets near-term relief in exchange for a bigger bill in the future. We reviewed the amount of PIK as a percentage of net investment income for several of the largest business development companies and found that ratio has ballooned from an average of about 10% in 2019 to more than 25% this year. While PIKs can be a useful tool in certain cases, the increased usage is likely signally either lack of liquidity or fundamental issues among the leveraged borrowers. We are talking about billions of dollars in financing.

Optimist vs. Pessismist

How do you see this playing out?

There is some warranted caution regarding BDCs, vehicles that are traded frequently, have structural leverage and lend to lower-quality companies. Such vehicles could become forced sellers, which is a cardinal sin in leveraged finance.

An optimist would say First Brands and Saks are idiosyncratic situations. But the pessimist could point to these signs of credit cracks and note they are occurring amid a strong economy, when the S&P 500 is up 17.5%. So, what happens to credit if the economy stalls?

Fixed Income Yields and Year-to-Date Returns

Ok, let’s turn to more positive observations. Where are you seeing opportunities in fixed income?

In the past few months we have leaned a little more into duration. I feel as long as the 10-year Treasury yield remains above 4% there is room for yields to move lower. I continue to favor investment grade corporate bonds amid a resilient economy. Also, the yields on floating rate loans are attractive, though potentially trending down. To be sure, investors should align with active management in floating rate loans, for all the reasons we have discussed.

Time for the random round. I’ll give you a word or phrase, and you tell me the first thing that comes to your mind. First: Gold rally.

Probably over.

Layoffs

The consumer's weakening. Looking at layoffs at consumer driven companies like UPS and Amazon supports that view.

US sanctions on Russian oil companies

Sanctions are today. That could change any moment.

Lululemon trademarking “Lululemon dupe”

Don’t know much about it. I think it’s meant to crackdown on copycats, but there’s usually a workaround. Seems ineffectual.

Too soon to decorate for Christmas?

Our neighbor did it October 30^th. So, there are Christmas lights in the neighborhood as of now. Maybe too soon, but let’s call it festive.

Let's close with a personal reflection.

I ran across a quote that kind of made me chuckle: “Silent gratitude isn't much use to anyone,” which has been attributed to Gertrude Stein. It seems apt for the Thanksgiving season. So, let’s all reach out and openly give thanks for the things and to the people that we are thankful for.

A 10-year Treasury note is a debt obligation issued by the United States government with a 10-year maturity period.

The Atlanta Fed GDPNow provides a running estimate of real GDP growth for the current quarter using available economic data.

Bank loans (or floating-rate loans) are financial instruments that pay a variable or floating interest rate. A floating rate fund invests in bonds and debt instruments whose interest payments fluctuate with an underlying interest-rate level.

A bond is a fixed-income instrument and investment product where individuals lend money to a government or company at a certain interest rate for an amount of time. The entity repays individuals with interest in addition to the original face value of the bond.

The Bloomberg US Aggregate Bond Index (Agg) is composed of investment-grade U.S. government bonds, invest-ment-grade corporate bonds, mortgage pass-through securities, and asset-backed securities, and is commonly used to track the performance of U.S. investment-grade bonds.

‍Capital Expenditure (CapEx) is the money a company spends to acquire, upgrade, or maintain long-term, physical assets.

Consumer Confidence measures consumers’ attitudes and optimism about the economy and their personal financial situation.

Coupon refers to the interest payment that a bond issuer promises to pay to a bondholder.

The Department of Government Efficiency (DOGE) is an initiative by the second Trump administration in the United States. Its stated objective is to modernize information technology, maximize productivity, and cut excess regulations and spending within the federal government.

Fixed income refers to assets and securities that pay a set level of income to investors, typically in the form of fixed interest or dividends.

Investment grade refers to the quality of a company's credit. To be considered an investment grade issue, the company must be rated at 'BBB' or higher by Standard and Poor's or Moody's.

An investment-grade bond is a type of bond that is considered to have a relatively low risk of default.

The ISM Manufacturing Index is a monthly economic indicator published by the Institute for Supply Management (ISM) that gauges the health of the U.S. manufacturing sector.

Treasury rate (or yield) refers to the interest rate at which the U.S. government borrows money by issuing Treasury securities.

Yield is the income returned on an investment, such as the interest received from holding a security.

A yield curve plots the interest rates of bonds that have equal credit quality but different maturity dates.

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