As we move into the traditionally quieter summer months, credit markets are benefiting from a period of relative calm. The tariff-related tail risks that dominated headlines earlier this year have diminished significantly, while volatility in swaps curves and government bond markets has subsided. With liquidity expected to thin seasonally, investors are increasingly focused on how to position portfolios in an environment that remains vulnerable to episodic surprises. There is no perception of systemic risk. The geopolitical overhang from trade tensions—originally triggered by the Trump administration and subsequently managed through a blend of assertive rhetoric and calibrated de-escalation—has lost market relevance for now although the real consequences will appear in some time from now. The risk-on mood recovered with stunning rapidity. Other geopolitical risks remained contained. In their place, monetary policy has re-emerged as the primary macro driver. Yet visibility remains limited. The path of interest rates in both the U.S. and Europe is uncertain, particularly with respect to the timing and depth of potential rate cuts. This ambiguity—amid concerns that the Federal Reserve may be behind the curve—is set to shape investor allocation decisions across credit portfolios, influencing both risk appetite and duration exposure. **What occurred and why** Market behavior in late May and during June reaffirmed a familiar pattern: geopolitical shocks tend to be short-lived in their impact on credit markets, while technical factors—particularly investor flows and healthy demand from hold to maturity final buyers—continue to exert the dominant influence on spread dynamics. To gauge the current credit landscape, it’s helpful to revisit the market responses following the volatility spike earlier this spring, particularly the period after Easter when U.S. rhetoric on tariffs softened noticeably. Once again, as seen before, market dynamics once again defied historical patterns, rendering past episodes a poor reference point for investors. 1. **During the early April sell-off, credit spreads widened but remained well within retrospective data trends (limited relevance as just said).** In Europe, investment-grade spreads widened by 25–30 basis points on average, while high-yield spreads moved roughly 75 bps wider. In the U.S., high-yield markets saw more pronounced moves, with average OAS widening of up to 150 bps. Despite the volatility, credit markets remained orderly and quickly repositioned for spread recompression, which materialized with notable speed. The U.S. sub-investment-grade spreads stayed comfortably below the 500 bps, the threshold typically associated with deteriorating macro conditions and elevated default risk. Overall, the credit markets stood out for their stability. I do observe that, when sellers show up in droves, the presence of a more sophisticated and deliberate demand base continues to act as a stabilizing force, effectively cushioning the market from sharp price dislocations (fueled by the usual chorus of alarmists who tend to overstate risks and contribute to unwarranted market anxiety). 2. **Investors in high-yield bonds and leveraged loans appeared confident in market liquidity and were generally able to hold positions through the volatility without incurring meaningful mark-to-market losses.** The Morningstar ELLI index touched a minimum around 95.55 (a little more than three figures down from the top at the end of February), while European high-yield bonds saw average price declines of just –3.0% to –3.5%—a limited drop relative to previous serious risk-off episodes. Structured credit markets were similarly contained in their reactions: in European CLOs, liability spreads of capital stacks widened by approximately 35 bps from tights of WACC around 185/190, while other ABS segments (with different investors involved, probably “buy and hold”) experienced more modest widening of around just 15 bps. Investors behavior suggests a sound analytical framework and a solid grasp of structured credit dynamics. The European ABS market returned to a steady flow of deals in May and June with tight spreads and tranches multiple times covered across both seniors and mezzanine tranches. The European Commission’s proposals to revise capital requirements for certain ABS structures have certainly contributed to establishing a more supportive backdrop for the market (the Securitisation Regulation reform will be known only next year). In my opinion given the volume of deals now coming in primary (CMBS issuance YTD is three times larger than first half of 2024), careful quality selection has become not just advisable, but essential, especially on mezzanine tranches. (my input is to read the documents…) Disruption has not materialized, but market conditions remain far from normal. Macro visibility is still clouded, and several companies carry unsustainable levels of debt while they generate little to no cash flows in the context of borrowers’ services of debt. Overheated bond and loan markets are lifting the prices of the instruments of debt of many borrowers that on the opposite should trade more in line with their asymmetric risk profiles and finally with realistic debt recovery analysis. Against this backdrop, portfolio positioning will increasingly hinge on expectations for policy normalization, Central Banks direction, and overall liquidity conditions. **Investors face a more complex and selective environment—one where active management, disciplined sector allocation, and liquidity awareness are likely to matter more than broad beta exposure.** I outlined this view back in January, and I continue to stand by it. The surge in primary IG and HY issuance, persistent oversubscription in transactions, the strange absence of new issue concessions for old and new names, aggressive financing through opportunistic add-ons or taps in loan or bond format, and unusually flat credit spread curves in Europe (which incentivize duration extension from issuers as I described in other posts) all highlight the distortions in today’s market. Perhaps most concerning is the growing prevalence of mispriced deals—often by more than 50/60 basis points of credit spread-not only versus my assessment but also against the same company’s term structure, the credit metrics, and comparables—signaling complacency and underscoring the need for caution and credit discipline also when yields are low and the risk is not remunerated. **I’ve previously written about how investors continue to allocate capital to mispriced deals, not because of fundamentals, but because the trades align with prevailing market trends.** In particular the CLO managers, one of the key protagonists in today's investment landscape, are compelled to remain active and put money to work, driven by the need to fill warehousing lines and deploy capital from already-printed vehicles seeking to build par value. **This dynamic has kept demand elevated, regardless of valuations, and is contributing to persistent mispricing in the HY space.** Price formation in the credit market has now been distorted for several months—arguably in a manner similar to how years of quantitative easing by Central Banks disrupted market signals and yield profiles suppressing the risk premia. Just as those “institutional interventions” skewed valuations, today’s technical pressures are again masking underlying credit risks. Investor appetite for “all-in yields” is skewing relative value assessments and compressing premia—challenging investors to rethink how they manage risk and identify opportunities, while effectively removing any cushion against potential market volatility. What I struggle to grasp is that during previous QE period the uncertainty and compression stemmed from an exogenous factor, whereas today the inefficiencies in capital allocation largely depends on the behavior of market participants themselves. No additional remarks will be made regarding this matter. To conclude, I want to highlight three brief points that were already evident ahead of the ABS conference in Barcelona: 1. **CLO portfolios are once again under pressure from a renewed wave of repricing,** which had briefly paused around Easter. In this environment, it is critical to understand how managers are positioning their portfolios and the strategies they are adopting to preserve the weighted average spread (WAS). Collateral credit selection (and this includes overlap percentages and CCCs), while still relevant, is likely taking a back seat to structural and portfolio-level decisions aimed at maintaining the overall economics of the arbitrage (someone in Barcelona said how CLOs remain “arbitrage vehicles and not funding structures”…. I find it a perfect definition). 2. **The timing of CLO resets (and refis) has become critically important for equity holders** —particularly in the context of assets repricing. Decisions involving portfolios that are outside the non-call period or beyond the reinvestment window play a critical role in shaping the final IRR of the subordinated tranches. As a result, equity investors must calibrate their cash flow models with greater precision, and maintaining a strong, proactive dialogue with the CLO platform has become more important than ever. CLO portfolio managers, for their part, must carefully make finely balanced decisions around the non-call and reinvestment periods, as the potential disadvantages and uncertainty (and costs) of short vehicles may outweigh the short-term benefit of lowering the weighted average cost of capital (WACC) at pricing. History has seen this play out more than once. **Effective management of liabilities and capital structure is equally critical to sourcing strong assets and constructing a robust, margin-generating portfolio.** A significant number of managers were late in acknowledging this structural reality. A comprehensive assessment of many CLO platforms should include this dimension of analysis. 3. **Ares recently priced a UK middle-market CLO.** While the new structure marks an improvement (improved design, optimized capital structure, and stronger characteristics) over European Barings’ November 2024 MM transaction, it remains a unique case difficult to reproduce. Europe has the potential to bring approximately €4 billion in MM CLO issuance to market, yet a clear, repeatable model has yet to emerge (my view). **Credit platforms capable of issuing CLOs backed by private credit assets must move beyond the established “comfort zone” of broadly CLO syndicated deals.** Achieving this will require a shift in mindset, disciplined ramp-up strategies, and active engagement with a different investor base. In two words: more work.

Key Takeaways from Hot June