Over the long arc of our careers, we have seen many radical changes in financial services. There are countless examples, but one that we have observed up close is the shift in how banks manage their balance sheets, specifically as it relates to commercial lending practices. Back in the day, banks would carefully underwrite their lending, as they would keep the assets on their balance sheet and use the interest income to run the bank. Eventually they realized they could substantially increase their fee velocity by syndicating loans to other banks and CLOs, thereby earning a higher return on capital. On the corporate bond underwriting side, new high yield and convertible bond deals would typically include a five-to-seven-day roadshow where the underwriters would take the issuer’s management team around the country to meet with institutional investors. The bookbuilding process took days or even weeks before the deals would close. Today, deals are frequently announced in the morning and priced the same afternoon. While we wonder whether a more lax attitude about underwriting standards is good for investors, at least the transition took decades to occur. Today, it seems the pace of change has accelerated, and significant structural shifts now occur before most investors have fully digested their implications. We offer this perspective because the third quarter featured several important changes, which we discuss below. As Bob Dylan wrote in 1964, “Then you better start swimmin’ or you’ll sink like a stone, for times they are a changin’.”
Federal Reserve policy has ebbed and flowed over the past decade. Under Janet Yellen, an avowed policy dove, the Fed kept post-GFC (Great Financial Crisis) interest rates very low, purportedly to protect the fragile economy from faltering. This lulled investors into feeling like money was, indeed, free. She typically shunned the limelight – her style was intentionally understated, and she very rarely shot from the hip. As we transitioned to Powell, we saw a much more active and public display of Fed activity with a total of 15 rate hikes and 10 rate cuts during his eight-year term atop the Fed. Press conferences were much more frequent than had occurred under Yellen, and the media dissected ad nauseum every word he said in hopes of gleaning some edge about what the Fed’s next move might be. Powell was quite willing to go off script and was almost omnipresent in front of the media. A cottage industry of Fed watchers sprung up. No phrase nor intonation went unanalyzed, and Powell seemed unbothered by that.
Now that Kevin Warsh is the Chair, how will things change going forward? He appears to be more hawkish, moving quickly with a hike in September to scale back the last five cuts that Powell had instituted. He also seems much more willing to play his cards close to the vest rather than to provide granular details about future plans. Could it be possible that his style and not just his actions contributed to the sharp selloff we have seen in the Treasury market over the last few months? Since Warsh’s appointment we have seen the 10-year U.S. Treasury yield rise over 70 basis points (bps), and the two-, three-, and five-year rates each rise by over 75 bps!
Of course, the prolonged conflict with Iran has significantly disrupted the oil and related commodity markets, contributing a great deal to current and forward inflation readings. Add to that an AI-fueled economy that is driving nominal GDP growth up to the 6-7% level, all-time high government deficit spending, and record government debt. Is it any surprise that yields have moved higher globally?
Pinning the entire rate move on Warsh’s style or semantics is unfair, but his less than open book communication approach will surely frustrate the many economists who had been spoon-fed by past Fed Chairs. The big question for us is whether Warsh will be able to keep the plates of the economy spinning on their spindles while rates push higher, government debt crosses $40 trillion, and interest expense approaches 20% of total government expenditures. It sure feels like the Fed at least may be swimmin’ upstream.
There is also substantial change in the capital markets. In 2025 we saw the beginning of what has become a tsunami of capital raising for the AI/digital infrastructure (read: data center) buildout. Heretofore, startup growth and development capital in the technology space had been financed by venture capital investors, but the capital needs for this massive buildout dwarf the available pool of money from venture capital firms. Bankers are good at dowsing for cash, and they found a seemingly bottomless pit of it in the debt markets. They have tapped most markets around the world such as investment grade (IG), high yield (HY), ABS/CMBS, and international markets in both U.S. dollars and foreign currencies. The speed and magnitude of the capital raises are unprecedented in the fixed income arena, especially since the majority of these projects are pre-revenue (with the exception of some of the neoclouds) with uncertain profitability at terminus. The careful analysis and caution typically associated with fixed income investors have clearly been set aside for now.
See more: Combining Growth Optimism With Fundamental Discipline
The allure of AI and perhaps the incremental coupon lured investors into lending almost $180 billion in 2025 across various debt markets – a prodigious sum for a nascent industry that has thus far been a free cash flow bonfire. As we moved into 2026, it was clear that the insatiable demand for capital among the AI/digital infrastructure cohort was going to continue unabated. However, it surprises us that the bolus of bond deals has been so easily swallowed by the markets. Through August, year-to-date issuance of $338 billion dwarfs what we saw for the full year 2025. We expect full year 2026 to be more than double last year’s haul! Issuance in these sectors approximates 17% and 18% of ALL new capital raised in the IG and HY markets, respectively. Among the most novel of these deals recently have been bonds used to finance the purchase of very expensive AI chips. Over $4 billion has been issued year-to-date, although still a drop in the bucket in the context of $338 billion, but an area that could be poised for meteoric growth if investors become more comfortable with chips as a financeable asset class, rather than simply a rapidly depreciating one. We have been interested observers so far as we believe that first, investors are receiving bond-like returns for equity-like risk and second, the sorting of winners and losers that always happens with major technological changes has not yet begun. Better to wait.
We completely understand the desire for equity investors to chase some of the returns that AI has delivered and promises to continue generating. However, when this much capital is raised so quickly, mistakes and misallocations of capital can easily occur. There are likely to be many tears shed when the parsing begins in earnest. It seems the more things change the more they stay the same, albeit bigger!
Another emerging shift in the markets is the weakening relationship between HY debt and equities. Historically, HY returns have been highly correlated with stocks, generally performing best during boom times, even during periods of rising interest rates. A strong economy and correspondingly supportive market sentiment have usually helped companies grow into their more leveraged capital structures through increased sales and cash flow, enabling them to pay down debt or raise capital for refinancing. But in the past few years, we have begun to witness a decoupling, led by the concentration of returns among mega cap technology stocks and a durable shift in structure of the sub-IG market. As we discuss in our 2025 publication, Addition by Subtraction, the quality of the HY market has increased significantly since the GFC, as many of the lower-rated borrowers have migrated to private credit. Currently, over 60% of the HY market is rated BB (highest rating HY) and just 8% rated CCC, which has increased interest rate sensitivity somewhat, so we need to keep our eye on the Treasury markets. Rates have moved up sharply since late August, causing five-year and seven-year U.S. Treasury notes to decline 2.59% and 3.42%, respectively. The ICE BofA U.S. High Yield Index has unsurprisingly lost 2.63% over the same time. Year-to-date performance still has high yield beating investment grade, though. Correlations in the short run will rarely be perfect, especially as there are some lower-rated bonds in the index that have been much more negatively impacted by the risk-off sentiment the market has endured over the past month, but the point is that the historically pro-cyclical relationship between the HY market and the equity market, as well as the economy, has weakened a bit, and high yield is, for now, more correlated to rates than it has ever been.
As Dylan wrote, “For the loser now will be later to win, for the times they are a changin’.” We know that line of thinking very well and think that it is particularly apropos regarding the bond market. The recent selloff and corresponding sharp rise in Treasury yields are now affording us some of the highest yields we have seen in the HY market in a few years. What is different this time is that we also have a strong economy and a higher quality market in which to capture these yields. In other periods where we have seen similarly tantalizing yields, like the GFC or the Covid pandemic, we were in the midst of periods that posed existential risks to large swaths of the economy. We do not see the same setup today. As mentioned earlier, the concentration of capital raised by the AI and digital infrastructure companies could create problems for investors in those sectors down the road. However, there are many other opportunities available to us to invest in strong companies that offer yields that have not been available outside periods of crisis. Consequently, we are starting to change with the times and are opportunistically looking, for the first time in several years, to lock in some of these higher yields for longer periods of time. Rates could still move higher, providing some headwinds, but the risk/reward pendulum has swung in our favor, and we feel it makes sense to selectively add some longer-dated exposure. We are diligently assessing the opportunities being created by the new, higher interest rate environment.
Timing any portfolio shift can be tricky. In past periods, the opportunities to move further out on the maturity and risk curve that were triggered by exogenous events proved to be short-lived given rapid Fed intervention. This can make it difficult to time the exact bottom precisely. However, it appears that the higher interest rate environment will be with us for a bit longer than we have seen in past crisis periods. Hopefully, this presents us with better and more lasting chances to reposition the portfolio to capture some of the higher yields we are beginning to see emerge in the markets. We are moving methodically but decisively to rotate into the bonds we believe will serve the portfolio very well for the next several years.
As always, we appreciate your confidence in us as we navigate “changin’ times.”
Carl Kaufman, CIO – Strategic Income & Managing Director – Fixed Income
Bradley Kane, Vice President & Portfolio Manager – Strategic Income
Craig Manchuck, Vice President & Portfolio Manager – Strategic Income
John Sheehan, CFA, Vice President & Portfolio Manager – Strategic Income
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Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period.
Investment grade/non-investment grade (high yield) categories and credit ratings breakdowns are based on ratings from agencies such as S&P, which is a private independent rating service that assigns grades to bonds to represent their credit quality. The issues are evaluated based on such factors as the bond issuer’s financial strength and its ability to pay a bond’s principal and interest in a timely fashion. S&P’s ratings are expressed as letters ranging from ‘AAA’, which is the highest grade, to ‘D’, which is the lowest grade. A rating of BBB- or higher is considered investment grade and a rating below BBB- is considered non-investment grade (high yield). Other credit ratings agencies include Moody’s and Fitch, each of whom may have different ratings systems and methodologies.
Yield is the income return on an investment, such as the interest or dividends received from holding a particular security.
Treasuries are securities sold by the federal government to consumers and investors to fund its operations. They are all backed by “the full faith and credit of the United States government” and thus are considered free of default risk.
The ICE BofA U.S. High Yield Index tracks the performance of U.S. dollar denominated below-investment grade corporate debt publicly issued in the U.S. domestic market.
The Bloomberg U.S. Aggregate Bond Index (Agg) is widely regarded as the standard for measuring U.S. investment grade bond market performance. This index does not incur expenses and is not available for investment. The index includes reinvestment of dividends and/or interest income.
Correlation measures the strength of association represents the degree to which the volatility of an investment is related to the volatility of the market during a given period. A Correlation Coefficient of +1 indicates a perfect linear association between an investment and the market, while a Correlation Coefficient of -1 indicates a perfect negative linear association. A value of 0 suggests a lack of association. This statistic provides no information about causation.
A basis point is a unit that is equal to 1/100th of 1%.
Collateralized Loan Obligation (CLO) is a single security backed by a pool of corporate debt, usually lower-rated, floating-rate bank loans.
An asset-backed security (ABS) is a type of financial investment that is collateralized by an underlying pool of assets — usually ones that generate a cash flow from debt, such as loans, leases, credit card balances, or receivables.
Commercial mortgage-backed securities (CMBS) are fixed-income investment products that are backed by mortgages on commercial properties rather than residential real estate. CMBS can provide liquidity to real estate investors and commercial lenders alike.
Source for any Bloomberg index is Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). Bloomberg owns all proprietary rights in the Bloomberg Indices. Bloomberg does not approve or endorse this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.
The S&P 500 Index is widely regarded as the standard for measuring large cap U.S. stock market performance. The index does not incur expenses, is not available for investment, and includes the reinvestment of dividends.
Coupon is the interest rate paid by a bond. The coupon is typically paid semiannually.
Maturity is the date on which the life of a transaction or financial instrument ends, after which it must either be renewed, or it will cease to exist.
Free cash flow represents the cash that a company is able to generate after laying out the money required to maintain and expand the company’s asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value.
Osterweis Capital Management is the adviser to the Osterweis Funds, which are distributed by Quasar Distributors, LLC. [OCMI-1016688-2026-10-12]
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