Pimco Says ‘Credit Loss Cycle’ Has Begun, Favors Quality Bonds

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(Bloomberg) — Pacific Investment Management Co. is warning that the “credit loss cycle is upon us” as heavy spending on artificial intelligence could widen economic outcomes and hit lower-quality borrowers.

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Pimco’s Richard Clarida, Andrew Balls and Daniel Ivascyn said in the firm’s latest annual secular outlook report that “the default cycle is reasserting itself, and we expect significantly higher losses in lower-quality credit such as leveraged and private direct lending.”

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Pimco, which manages $2.3 trillion in assets, said the AI buildout could widen the range of economic outcomes over the next five years while leaving weaker and more heavily leveraged borrowers more exposed.

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High-grade credit spreads — the extra yield investors demand over US Treasuries to hold highly rated corporate debt — remain near their lowest levels in almost three decades. Demand for riskier debt has also held up despite a recent global bond selloff, as higher yields draw buyers.

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Pimco said that backdrop clashes with “elevated secular uncertainty,” and “we interpret this as complacency rather than strength.”

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The firm also pointed to “increased instances of maturity extensions and payment-in-kind structures that allow borrowers to repay debt with more debt,” a trend it said suggests “a more genuine default cycle is now unfolding, and investors should not expect past patterns of rapid recovery to repeat with the same reliability.”

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Pimco said one effect of the AI boom could be lower wage pressure and higher productivity, which it described as “a powerful disinflationary force, but geopolitical shocks and supply chain reconfiguration will likely put upward pressure on prices.”

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Against that backdrop, Pimco said “central banks will do what it takes to keep inflation expectations anchored over the next five years,” and that “for this reason, sovereign bonds offer income plus the potential for capital gains in a future downturn.”

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The authors also noted that the “historical frequency of US recessions over five-year periods since World War II has been 69%,” and wrote, “Central banks have much more room to cut rates in future economic downturns than in the decade before the pandemic, and we expect them to use it.”

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At the same time, elevated debt and persistent deficits in developed economies “limit fiscal space, but do not, in our baseline view, imply that a US fiscal crisis is imminent,” the authors said. “The dollar’s reserve status affords the US more flexibility than other sovereign issuers,” but the country “remains on an unsustainable trajectory under current policy, which continues to kick the can down the road.”

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In that context, “owning non-US debt can be a prudent way to diversify,” they said.

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So far this year, the asset manager has weathered a weak period for US bonds. Pimco’s flagship $228 billion Income Fund has returned 0.3%, beating 66% of peers. Over the past three and five years, the fund has outperformed 90% of rivals, and it is up 7.8% over the past 12 months.