Q3 2026 Credit Research Outlook High rates, tight spreads, and the case for quality cash

Major global central banks risk damaging the long-running credit cycle if persistent inflation forces additional rate hikes over the next few quarters. The current credit backdrop still reflects a mature-cycle environment, with rich valuations leaving risk assets exposed to repricing and volatility. In that context, the ability of monetary policy to cushion the cycle is constrained.

The central issue is that inflation is no longer the result of a single shock, but rather the layering of several potential waves: tariff effects, higher energy prices, and AI-related capital spending pressures. AI-related investment may add near-term inflation pressure through elevated demand for power, data centers, infrastructure, equipment, and skilled labour, even if it ultimately supports productivity gains over a longer horizon. A benign outcome would require these inflation waves to peak and fade without destabilizing inflation expectations, while underlying inflation continues to moderate on the back of productivity gains and contained wage growth. This remains a plausible path, but it is not assured.

If inflation expectations drift higher and labour markets remain firm, central banks could feel compelled to tighten more aggressively than underlying growth can withstand while still keeping economies in expansion territory. In that scenario, the principal credit-market damage from policy over-tightening would likely appear first in weaker and more rate-sensitive areas of credit, including high yield, leveraged loans, non-investment-grade private credit, vulnerable segments of commercial real estate, and subprime consumer finance. Over time, stress in those areas could broaden into wider risk-asset volatility and tighter financial conditions.

At the same time, the broad credit and economic cycle can persist through a period of structurally higher interest rates. The post-2022 experience demonstrated that major global central banks could raise policy rates sharply over a compressed period without triggering a broad breakdown in economic activity or financial conditions. In the US, the durability of the expansion has been supported by resilient spending, broadening capital investment, and AI-related capex, which have helped offset consumer price pressures and tighter nominal financing costs. In our view, financial conditions can remain relatively unrestrictive if debt and equity capital continue to flow toward companies demonstrating earnings growth, margin expansion, and durable cash generation.

Despite this demonstrated resilience, we continue to see two primary threats to credit markets and financial conditions:

• Potential investor complacency as reflected in historically tight credit spreads
• The vulnerability of companies and issuers with weaker credit fundamentals, higher leverage, and acute refinancing needs.

US investment-grade and high-yield spreads have remained notably resilient through 2026 despite recurring macro and geopolitical volatility, suggesting that credit markets continue to place greater weight on still-solid fundamental conditions than on headline risk. In investment grade, stable leverage, strong interest coverage, positive ratings migration, elevated all-in yields, and persistent demand have helped absorb bouts of volatility, even as spreads remain historically tight and issuance has been heavy.

In high yield, aggregate market credit quality, manageable near-term default expectations, and supportive income carry have similarly limited spread widening, despite pressure points among lower-quality issuers, leveraged private credit borrowers, subprime consumer exposures, and sectors vulnerable to higher input costs or refinancing stress.

The key credit concern is that current spread levels may now embed a relatively benign macro path and leave limited cushion for fundamental deterioration. Resilient pricing is justified to the extent earnings, employment, liquidity, and default trends remain stable. However, the persistence of tight spreads amid policy uncertainty, geopolitical shocks, and late-cycle risks also raises the possibility of investor complacency and under-compensation for downside tail risk.
 

We remain wary of that complacency, given that speculative-grade default rates remain elevated relative to long-term norms, with US defaults at approximately 4.0% versus a 20-year median of 2.9%, and European defaults at 4.6% versus a 20-year median of 2.3%.

If the interest-rate environment becomes less supportive, these elevated default levels could persist, particularly among lower-quality issuers with weaker refinancing flexibility and limited free cash flow coverage. To be fair, the market has shown some degree of credit discrimination: CCC default rates in both regions remain materially above long-term averages, and CCC spreads have widened meaningfully relative to higher-quality high-yield debt.

As the accompanying chart shows, the spread differential between CCC-and-lower US high-yield bonds and single-B bonds now exceeds 600 bps, having widened by roughly 200 bps year to date. While this dispersion indicates that investors are penalizing the weakest credits, the broader resilience of investment-grade and high-yield spreads may still understate downside risk if credit fundamentals begin to deteriorate more broadly.¹

The near-term outlook for global speculative-grade credit is becoming more bifurcated. AI-related disruption risk is likely to intensify in select sectors, particularly software, where business-model disruption, margin pressure, or slower revenue growth could weaken operating cash flow and credit fundamentals. These pressures could spill over into both broadly syndicated loans and private credit valuations. At the same time, refinancing risk should rise if rates remain elevated and growth slows, especially for debt issued during the ultra-low-rate period surrounding the COVID-19 pandemic.

For highly leveraged issuers, the combination of weaker cash flow and a higher cost of capital could become increasingly difficult to absorb. As a result, conditions appear sufficient for a meaningful default cycle in certain areas of the credit markets, even absent a recession.

Implications on the cash investment universe

The global cash investment universe is concentrated in debt issued by large global banks and financial institutions. Operating conditions for these issuers remain strong, and several favorable trends from recent quarters have persisted despite volatility tied to energy prices, private credit, and AI-related risks. Most banks in our universe continue to report modest profit growth, supported by fee income, resilient investment banking activity, and measured loan growth. Credit profiles also remain underpinned by strong capital positions, sound balance sheets, robust liquidity, and solid asset-quality performance.

Higher-for-longer rates can be supportive for bank profitability, but only when rising long-term yields reflect a reflationary backdrop: stronger nominal growth, a steeper yield curve, healthier loan demand, and wider net interest margins. In that environment, banks benefit from maturity transformation and operating leverage, and profitability tends to improve alongside higher long-end yields.

The relationship can reverse under stagflation, however, where yields rise despite weakening growth, restrictive policy, and a flatter curve. In that scenario, limited net interest margin upside can be outweighed by weaker loan volumes, higher credit costs, and pressure on securities portfolios. If energy-flow disruptions prove temporary and oil prices normalize, the stagflationary pressure on bank earnings, asset quality, and credit fundamentals should moderate.

Still, even in a more constructive reflationary scenario, we are concerned about the potential for a meaningful default cycle in certain areas of the credit markets. Rising defaults among smaller, highly leveraged, sub-investment-grade borrowers appear increasingly likely, particularly if elevated interest rates persist and refinancing conditions become more challenging.

Importantly, this does not mean the risk transmits evenly across the financial system. As we described in our last quarterly publication, banks in our investment universe do not have significant direct exposure to these types of borrowers, but they have materially increased lending to nonbank financial institutions, including private credit lenders.

While this represents an important area of monitoring, we believe the large global banks in our investment universe remain comparatively well insulated from a potential private credit default cycle. Their exposure is generally positioned at the top of the capital structure, with lending structured as senior secured financing rather than direct participation in the riskiest borrower-level debt or equity exposures.

Private credit is concentrated in smaller, more economically sensitive borrowers, typically with $50–$100 million of EBITDA and balance sheets below $1 billion. These borrowers are inherently more exposed to economic shocks, weaker cash flow, and higher refinancing costs. However, even under a stressed downside scenario, secured lenders retain roughly 4.0x effective asset coverage, meaning losses are expected to be absorbed first by junior creditors and equity rather than by senior bank debt.

The pressure is therefore more likely to manifest through impaired unsecured debt and equity value, particularly given private credit’s heavier software exposure and nearer-term maturity wall, rather than through systemic losses to the traditional banking sector.²

For cash investors, the key distinction is between stress in riskier credit markets and credit impairment within the high-quality financial institutions that comprise our approved investment universe. We expect elevated rates and refinancing pressure to continue challenging weaker speculative-grade borrowers, particularly in private credit, highly leveraged loans, select commercial real estate exposures, and subprime consumer finance.

However, the large global banks on our credit approval list remain supported by historically strong capital, robust liquidity, sound asset quality, diversified earnings, and limited direct exposure to the credit segments most sensitive to elevated nominal interest rates.

As cash investors, we evaluate counterparties through a consistently conservative lens. Current credit-market risks reinforce the relative value of high-quality assets. While prolonged higher rates are creating a more challenging backdrop for riskier segments of the credit market, our focused investment universe is designed to limit material direct and indirect exposure to the areas we view as most vulnerable to a default cycle over the next year or two. We remain alert to broader credit-market deterioration, but continue to view high-quality bank obligations as relatively resilient within the Global Cash investment universe.