The credit market appears calm on the surface, but a $1 trillion "misalignment" is spreading beneath the surface.

While global government bond yields continue to climb, the investment-grade credit market appears calm on the surface, but significant divergence has emerged internally.

According to Bloomberg analysis, approximately $1 trillion in corporate bonds are trading at spreads significantly deviating from their credit ratings. Of this, about $580 billion is in the US and about $400 billion in Europe, all of which are non-financial investment-grade securities with remaining maturities exceeding three years. This massive "credit misalignment" contrasts sharply with the overall market's low volatility.

For actively managed funds, this means both risk and opportunity: bonds with exceptionally wide yield spreads can not only offer higher coupons, but may also generate additional capital gains if valuations eventually recover.

Matthew Jackson, Global Investment Grade Portfolio Manager at Robeco, said that overall yield spreads are “unremarkable” and are unlikely to change much in the short term, but there are still plenty of opportunities to be explored at the industry, sub-industry, and individual bond levels.

The surface appears calm, but internal differentiation has already emerged.

Overall, the investment-grade credit market has issued virtually no warning signs. The average spread for US investment-grade bonds is 78 basis points, just a few basis points away from its lowest level in nearly 25 years; the average spread for European investment-grade corporate bonds is 79 basis points, also close to its lowest level since the financial crisis. The 60-day volatility of global investment-grade spreads is also near a five-year low.

Even with a global bond sell-off this week and government bond yields rising to near 20-year highs, investment-grade corporate bond spreads remained virtually unchanged: the Eurozone spread widened by less than 1 basis point, and the US spread widened by only 0.3 basis points.

However, the calm indices masked a sharp divergence at the individual bond level. Bloomberg data shows that as of late August, the spreads on bonds issued by 25 A-rated borrowers across five U.S. sectors were already higher than the BBB spread curve. Meanwhile, since the summer, the volume of investment-grade debt traded at spreads higher than junk bond equivalents has also continued to increase.

Massive AI funding is impacting the credit market.

The massive financing by hyperscale technology companies is one of the key drivers of the current growing misalignment in the credit market.

In the quest for AI dominance, tech giants are issuing bonds on a massive global scale, and their weighting in US investment-grade bond indices has risen to approximately 5%, doubling from two years ago. This rapid increase in index weighting has also forced some fund managers to proactively reduce their concentration, thereby creating new pricing distortions in bonds outside of AI leaders.

Nick Elfner, co-head of research at Breckinridge Capital Advisors, said investors need sufficient compensation from both issuer credit quality and market supply pressures, which is why some related bond spreads have widened. He pointed out that the widening spreads reflect both the risk of potential credit quality deterioration and the technical pressure brought about by the massive issuance of new bonds.

The sources of pressure vary across different industries: automakers face fierce competition, software companies bear the risk of disruption from AI, and insurance companies are punished by the market for holding higher-risk private credit assets.

The European credit market also needs to look to France.

European markets face additional political variables. Barclays credit strategist Soren Willemann lists the French presidential election next April as a key risk factor, and believes that there is limited upside potential for a constructive stance on French risk assets at present, and investors need to closely monitor the performance of related French assets.

It's worth noting that misalignments within investment-grade rating ranges typically don't immediately trigger forced selling, but the spread can narrow rapidly if more investors chase the same trade. Meanwhile, credit markets across different sectors are often driven by their own independent factors; the financing expansion of mega-technology companies is not necessarily correlated with the energy market.

Jackson concluded that the credit cycle today "no longer looks so simple," and there is no longer a single cycle that can be applied universally.

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