The high-yield market generated strong returns in 2025, though under the surface, key themes continued to drive the market, increasing speed of cycles, sector dispersion, and idiosyncratic risk. The speed of cycles is a topic we have discussed for several years and was on full display in 2025; with 16 instances of over 30bps moves in HY Index OAS. The shortening of cycles demands higher levels of organization, market presence, and intentional focus while presenting opportunities to drive outperformance from both security selection and sector rotation. Sector dispersion is expected to remain high as AI-winners and losers continue to emerge, and the administration plays an active role in shaping markets in alignment with policy objectives ahead of the midterms. Idiosyncratic risk highlights the importance of security selection and avoidance. With spreads near post-GFC tights and generally optimistic expectations built into security prices, the cost of being wrong is high. Earnings misses and other negative developments often sent securities down 10 or more price points as expectations reset. This dynamic is expected to persist in 2026, reinforcing our longstanding emphasis on disciplined, proactive risk management, with heightened attention to event-driven risks.
The high-yield market enters 2026 on strong fundamental footing, though the margin for error has diminished. Corporate balance sheets remain robust; default rates are contained and near-term earnings visibility is stable. At the market level, fundamental quality is reflected in a historically elevated share of BB-rated bonds after years of positive ratings momentum. This is not a market under stress. What has changed is how forward returns are likely to be generated. In prior years, improving fundamentals, discounted dollar prices, and wider spreads were supportive of above-coupon return generation. These return tailwinds have diminished, creating a higher likelihood of below-coupon forward returns and placing even greater importance on portfolio construction and risk selection.
Fundamentals continue to support the market, but the direction of change now matters more than the starting point. Corporations are acting more assertively as confidence returns and capital markets remain open. Sponsor activity is on the rise, and leverage is re-emerging in select segments. The recent record-setting amount of leveraged buyouts (LBO) underscores this shift. These dynamics are not inherently negative, but they compress tolerance for execution error. Strong fundamentals provide stability, not immunity.
In 2026, fundamentals define the floor, but valuation, supply, and execution will determine the ceiling. We believe the math behind the market starts on less favorable footing than in the past few years. High-yield spreads sit near historical lows, leaving limited room for further compression without a clear catalyst. Yields have normalized toward long-term averages, although yield breakevens remain supportive with market duration historically short. In this environment, outcomes depend less on exposure and more on selection, particularly avoiding credits where leverage, refinancing risk, or capital allocation decisions undermine risk-adjusted returns.
Net new high-yield issuance is expected to rise materially in 2026, roughly 50% above 2025 levels and more than double volumes seen in 2024. This increase is driven by an expected resurgence in M&A activity and non-refinancing corporate demand. Fallen angel volumes in excess of rising stars could add further supply to the high yield market. An excess supply environment would be a change from the 2021-2025 period in which demand consistently exceeded supply and would likely necessitate changes in single name, sector, and portfolio positioning strategy.
Smith Capital Investors maintains a cautious approach to the leveraged loan market as we enter 2026. We see headwinds for the asset class at the fundamental, technical, and valuation level. The fundamental backdrop in leveraged loans has continued to deteriorate, as evidenced by credit rating downgrades exceeding upgrades for 42 of the last 44 months. The B3-rated part of the market stands near historic highs, creating risk that further downgrades to Caa could result in forced selling from rating-sensitive holders. Further technical headwinds result from expectations for elevated supply as increased LBO activity drives higher net issuance. On the valuation side, market expectations for falling interest rates could lower floating rate coupons, and the relative yield pickup in loans versus high-yield bonds is less favorable than much of the 2022-2025 time period. Despite caution on leveraged loans, in general, we remain actively engaged in the market, focused on the highest quality loan-only issuers, issuers with both loans and bonds outstanding, and issuers with capital allocation strategies focused on credit improvement.
Short-duration high yield represents an area of the market we find particularly compelling in 2026. In our view, carry remains attractive relative to duration risk and visibility in near-term cash flows is high. Elevated primary issuance and active capital markets continue to support front-end takeouts, reducing exposure to refinancing risk. Most importantly, strong fundamentals can create business and capital structure resiliency to handle future volatility and uncertainty without sharply increasing default risk. We are also positioning opportunities driven by capital-structure change rather than isolated spread movement. Strategic M&A activity, increased investment tied to artificial intelligence, and rising fallen-angel volumes are creating identifiable supply events that can lead to dislocations. These are not broad market calls, but specific situations where preparation, rigorous analysis, and decisive action matter. These dynamics represent an active area of focus as 2026 unfolds, alongside our unwavering focus on identifying issuers and management teams focused on deleveraging and capital structure improvement.
Leveraged finance in 2026 is likely to reward intention. Supportive fundamentals and active markets provide opportunity, but tight valuations and rising supply demand precision. Guided by our North star, Participate and Protect—we approach this market with disciplined participation where risk is compensated and a steadfast focus on capital preservation where it is not. In a year defined by dispersion, value creation will come from selectivity, judgment, and an active understanding of where risk-adjusted returns truly reside.
Let’s Talk.
The opinions and views expressed are as of the date published and are subject to change without notice. Information presented herein is for discussion and illustrative purposes only and should not be used or construed as financial, legal, or tax advice, and is not a recommendation or an offer or solicitation to buy, sell, or hold any security, investment strategy, or market sector. No forecasts can be guaranteed. Any investment or management recommendation in this document is not meant to be impartial investment advice or advice in a fiduciary capacity and is not tailored to the investment needs of any specific individual or category of individuals. Opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to change at any time due to changes in the market or economic conditions. There is no guarantee that the information supplied is accurate, complete, or timely, nor are there any warranties concerning the results obtained from its use. It is not intended to indicate or imply that any illustration/example mentioned is now or was ever held in any portfolio.
The information included in this letter and provided link may contain statements related to future events or developments that may constitute forward-looking statements. These statements may be in the form of financial projections or may be identified by words such as “expectation,” “anticipate,” “intend,” “believe,” “could,” “estimate,” “will,” “should” or words of similar meaning. Such statements are based on the current expectations and certain assumptions of the author and are, therefore, subject to certain risks and uncertainties. A variety of factors may affect the operations, performance, business strategy and results of the issuer, and could cause the actual results, performance or achievements of the issuer to be materially different from any future results, performance or achievements that may be expressed or implied by such forward-looking statements or anticipated on the basis of historical trends.
Past performance is no guarantee of future results. Investing in a bond market is subject to risks, including market, interest rate, issuer, credit, inflation, default, and liquidity risk. The bond market is volatile. The value of most bonds and bond strategies are impacted by changes in interest rates. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens. High yield or “junk” bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.
You should not construe this paper as investment, legal or tax advice. It does not take into account the investment objectives, financial situation and particular needs of any investor. Please consider the charges, risks, expenses, and investment objectives carefully before investing. Please see a prospectus, or, if available, a summary prospectus containing this and other information. Read it carefully before you invest or send money. Investing involves risk, including the possible loss of principal and fluctuation of value. This material may not be reproduced in whole or in part in any form, or referred to in any other publication, without express written permission from Smith Capital Investors. Smith Capital Investors, LLC is a registered investment adviser with the Securities and Exchange Commission (“SEC”). Registration does not imply a certain level of skill or training.
FOR INSTITUTIONAL INVESTOR USE ONLY SCI00799
