Market Recap

Markets ultimately delivered strong returns in all asset classes in 2025, with the S&P 500 up +17.88%, small caps (Russell 2000 Index) up +12.81%, High Yield up +8.60%, Investment Grade up +7.78%, and 10-Year Treasuries were up +7.35%. Loans trailed at +5.94% but remained a consistent monthly performer.

Credit outperformed in December, with High Yield up +0.65% and Loans up +0.68%. Equities were mixed, with the S&P 500 up +0.06% and the Russell 2000 Index down -0.58%. 10-Year rates climbed 15bps to +4.17%, pressuring longer duration assets. Investment Grade Corporates were down -0.29% and 10-Year Treasuries were down -0.95%.

2025 brought some notable challenges and concerns. The return of the Trump administration quickly introduced policy-driven volatility. Despite optimism around resilient growth and strong corporate fundamentals, volatility rose sharply as tariffs, trade policy, geopolitics, and fiscal actions increasingly influenced market pricing. The “Liberation Day” tariff announcements in March-April triggered equity drawdowns and rate volatility but also highlighted the relative defensiveness of credit versus equities.

As the year progressed, tariff-related volatility faded as tariff policy was increasingly viewed as a negotiating lever by U.S. policymakers, which tempered concerns about lasting economic damage. In addition, monetary policy proved supportive in the second half of the year. The Fed cut rates in September, October, and again in December, lifting risk asset valuations. Since September 2024, the Fed has reduced short-term interest rates by close to 2%. Additional support may come from a pause in balance sheet reduction, with several Fed presidents indicating a preference to hold the balance sheet steady. Labor markets softened in 2025 but remained structurally tight. Reduced net immigration limited labor force growth, while an aging workforce constrained labor supply, keeping inflation risks symmetric rather than deflationary.

Looking ahead to 2026, several policy developments may support markets. The effects of accommodative monetary policy actions have yet to fully flow through the economy and the Fed has ended balance sheet runoff while potentially adding liquidity through renewed asset purchases. The Fed’s balance sheet has increased $30bn since its recent low on December 3rd. A forthcoming Fed leadership appointment by President Trump may reinforce the current rate- cutting trajectory. Fiscal policy is also accommodative, as provisions of the One Big Beautiful Bill begin to be implemented. One development that has received limited attention—but is supportive of markets—is the change to the maximum interest deduction, which will shift to 30% of EBITDA from 30% of EBIT starting in 2026. This change will directly increase cash flow for many below-investment-grade companies. AI-related capital spending added roughly 1% to GDP growth and is expected to continue at its 2025 pace into the new year. The World Cup being held in North America should also drive international tourism and increase economic activity.

The trajectory of the AI narrative is also one of the bigger risks for the market, particularly if the perceived growth trajectory for AI comes down. A reassessment of the AI outlook could have spillover effects across broader risk appetite, especially given the increasingly circular nature of many AI capex agreements, which are amplifying reported growth rates and concentrating equity market performance in a narrow group of beneficiaries.

A notable divergence emerged in global rates markets in 2025. The U.S. 10-year treasury rate declined 31bps in 2025 to end the year at 4.17%, while rates across the rest of the developed world moved higher. Strategas pointed out in late December that, Japan, Australia, Germany, Canada, and France all saw rates notably higher in the year. Gavkal highlighted inflation as one of the most obvious market mispricings. They look at the breakeven spread between nominal and inflation-linked bonds, which implies that inflation will be exactly at the Feds 2% target over the next 5, 10, 20, and 30 years. This suggests that inflation will fall below the Feds 2% target in 2027 through the end of the decade. Their view is that structural forces support higher inflation in the U.S., including deglobalization and protectionist policies, labor market tightening from demographic aging and lower immigration, political pressure for a higher share of wages in national income, and increased market concentration. They expect these forces to outweigh the downward price pressures from artificial intelligence.

The majority of strategists expect 2026 fixed income returns across sectors to be driven primarily by coupon income rather than price appreciation. Economic activity is supportive and corporate fundamentals are showing strength and improvement. M&A activity is expected to improve as borrowing costs have declined. We already have a couple of large private transactions announced that will close and fund in 2026. According to market strategists, High Yield is expected to return 5%-6.5%. Loans are expected to be in the 4.9% to 5.8%. Private Credit is expected to generate 5.4%-6%. Investment grade is expected to generate 4.4%-4.9%. Default activity is expected to decline steadily from current levels.

High Yield

“Remarkably resilient” is likely to be the 2026 theme for HY. Coupon is the major driver of expected returns with some modest spread widening. A driving theme within HY for 2025 was the structural improvement in quality, as BBs continued to increase as a percentage of the market. Citi noted that with HYs shorter tenor and higher quality bias the yield-to-worst is increasingly the best predictor of returns.

We (and many others) highlighted throughout the year that spreads are tight. There are a few key reasons that have driven this. 1) HY duration has declined, which reduces the price sensitivities to changes in spreads and yields. 2) The mix of secured versus unsecured has changed dramatically, with secured comprising over one-third of the index today. Within Single-Bs, secured makes up over half. 3) Ratings migration has seen the index comprised of a significantly higher mix of BBs than in the past, while CCC has also declined. According to Barclays, after adjusting for changes in market composition, HY spreads would have reached an all-time tightest level of 167 basis points, compared with 233 basis points in May 2007. On this adjusted basis, today’s HY spreads rank in the 27th percentile historically, rather than the 8th percentile on an unadjusted basis.

Loans

Loans delivered steady, income driven returns, though performance increasingly depended on credit selection as opposed to beta. A recurring theme in our discussions on loans is that outperformance comes from avoiding problems rather than chasing yield. The collapse of First Brands in September was a stark illustration of this dynamic. Despite isolated problems, loan fundamentals remain sound overall. Revenue and EBITDA growth stayed positive.

Coupon income is expected to be the main driver of loan returns in 2026. Coupons are expected to decline from the current year-end level of 7.1%, driven by lower projected SOFR rates and additional repricing of loans that continue to trade above par. Spreads are expected to widen according to majority of forecasts but not materially.

CLO demand provided a stabilizing buyer during periods of volatility in 2025. This factor is expected to lessen in 2026 as CLO new issue activity is unlikely to remain at 2025’s elevated levels. CLO supply is expected to decline around 20%.

CLO

CLOs were a core stabilizing force throughout 2025. Despite volatility in underlying loans, CLO creation remained robust, supported by attractive arbitrage, improving portfolio quality, and strong demand, especially for AAA tranches.

Portfolio quality steadily improved: CCC exposure declined, WARFs fell back toward early-2022 levels, and median CLO default rates remained well below the broader loan market. Even notable credit events (e.g., First Brands) were absorbed due to diversification and concentration limits.

A major late-year tailwind was the return of large institutional buyers and continued inflows into CLO ETFs, particularly at the top of the capital structure. Spreads remained wider than pre-Liberation Day lows, leaving room for further tightening and reinforcing CLOs as one of the most attractive risk-adjusted opportunities in structured credit.

Source: Barrow Hanley. Returns represent an asset-weighted composite of all Bank Loan Fixed Income portfolios or High Yield Fixed Income portfolios. Index returns are shown before transaction costs, management fees, and other expenses. Performance is expressed in U.S. currency. Net-of-fee returns are calculated us- ing a model fee. The model fee is based on a $100 million portfolio using our standard fee schedule. Past performance is not indicative of future results. Inception Date for Bank Loans is June 1, 2018. Inception Date for High Yield is January 1, 2005.