Will High Yields Crack the Market’s Resilience?

Andrew Sheets · Morgan Stanley

Lower-rated credit is under strain: CCC spreads have widened and weaker credits suffer as rates stay high.

Under the surface, market resilience is not as apparent as headline spreads suggest. Spreads on the lowest-rated CCC credits have increased significantly this year in both the US and Europe. Sheets argues that rates needed to balance a strong technology and spending boom are not the rates that keep smaller, weaker or more indebted companies healthy, so the weaker tails of the market can still suffer. He draws a parallel to 2005, when booming capex and housing pushed rates up, the overall economy held up for several more years, but weaker credit pockets were challenged much sooner.

“If higher rates are needed to balance things overall, the weaker tails of the market can still suffer.”at 3:28

Andrew Sheets · Morgan Stanley

Favor an upward quality bias: high yield bonds over loans, and decompression across credit indices.

Sheets argues that the weaker tails of the credit market can suffer as rates stay high, as happened in 2005 when the economy held up for years while weaker credit struggled sooner. He therefore expects a similar pattern today and favors an upward quality bias in credit positioning. Concretely, this means preferring high yield bonds over loans and favoring decompression across credit indices.

“We think the same may be true today and therefore favor an upward quality bias. We favor high yield bonds over loans and decompression across credit indices.”at 4:03

Andrew Sheets · Morgan Stanley

Current interest rate levels are not clearly wrong; conditions look too hot rather than too cold.

Growth in the US, Europe and Asia remains surprisingly robust this year, and inflation across regions is still generally above central bank targets. That is a sign conditions are more likely too hot than too cold. Rates that were truly too high would be curtailing activity and pushing inflation below target, which is the opposite of what is being seen. The yield curve reinforces this: it is not inverted, which would signal markets believe rates are too high and will need to be cut as conditions weaken. Sheets argues the current level of rates is okay for now.

“And I don't think it's clear that they are.”at 0:45

Andrew Sheets · Morgan Stanley

Huge AI spending is largely insensitive to interest rates, keeping growth strong despite higher yields.

Part of the reason the economy is holding up despite higher rates is the scale of AI spending. That spending has been very insensitive to the level of interest rates. Because of this, the usual slowdown that higher rates would bring is not showing up in growth data, which supports the view that current rates are not obviously too high.

“Thanks in part to the scale of AI spending and how insensitive the spending has been to the level of interest rates, we're just not seeing this.”at 1:14

Andrew Sheets · Morgan Stanley

Listed BDCs trading at widening discounts to book value signals stress in lower-rated private credit.

Publicly traded BDCs, which contain portfolios of lower-rated private credit, have traded at widening discounts to their book value this year. Because the market prices these vehicles below the value of their loan books, it signals that investors are marking down the risk in lower-rated private credit. This is part of the evidence that the apparent resilience of markets is not as solid under the surface, consistent with the weaker tails of credit being challenged by higher rates.

“Publicly traded BDCs, which contain portfolios of lower rated private credit, have traded at widening discounts to their book value.”at 2:23

Andrew Sheets · Morgan Stanley

Stock market resilience is superficial; most large US stocks have suffered deep drawdowns since yields rose.

Although US and European stocks have posted double-digit gains this year, the underlying picture is weaker. Citing his colleague Mike Wilson and the US equity strategy team, Sheets notes that over half of the 3,000 largest US stocks have seen a drawdown of at least 20% since June, which is the month yields started to rise. The index-level strength therefore masks broad damage across the market, undercutting the idea that markets are truly resilient to higher rates.

“[Over half of the 3,000 largest stocks] have seen a drawdown of at least 20% since June, which happens to be the month that yields started to rise.”at 2:42

Andrew Sheets · Morgan Stanley

Global growth appears less sensitive to higher rates than expected, so the economy can absorb higher yields.

Growth has been surprisingly robust in the US, Europe and Asia this year despite a large rise in yields. Sheets argues this suggests global growth is simply less sensitive to higher rates than was initially expected. Deficits and AI spending are offered as explanations. This implies the economy can absorb higher yields without a sharp slowdown, though weaker credit pockets may still suffer.

“2026 may be showing that global growth overall is just less sensitive to higher rates than was initially expected.”at 2:51

Andrew Sheets · Morgan Stanley

Large government deficits in the US, Europe and Asia help explain why growth is less rate-sensitive.

Sheets suggests 2026 may show that global growth is less sensitive to higher rates than initially expected. Large government deficits in the US, Europe and Asia, together with large AI spending, are offered as two reasons why. Deficit-driven spending adds demand to the economy, which helps offset the drag from higher borrowing costs and keeps activity and inflation running above target.

“Large government deficits in The US, Europe, and Asia, and large spending on AI may be two reasons why.”at 2:58