Ares Global Credit Monitor - Second Quarter 2025
The Move That Changed the Game: A Tale of (Yield) Curves
In March 2016, an AI system called AlphaGo faced Lee Sedol, one of the greatest Go players in history. AlphaGo quickly made a move so strange—Move 37—that commentators thought it was a mistake. It wasn’t. It was a tactic no human would have considered, breaking centuries of convention and ultimately securing the win.
In a world where the traditional moves of stocks, bonds and cash all yield nearly the same amount, the lesson is clear: Mastering the old game better isn’t enough. Successful investing now demands innovation, venturing into the less orthodox and assessing the risk and return. Specifically, it warrants a look at alternative assets where strategies remain underinvested, and premiums persist for those bold enough to leave the old ways of thinking behind.
Converging Yields, New Frontiers
Today this convergence of yields across major asset classes continues. The yield on equities, government bills and bonds and investment grade corporate bonds have all converged between 4 to 5%1.
Typically, these asset classes offer distinct risk return profiles, with equities typically offering higher return for higher risk, and government debt offering lower more stable returns with a premium for longer duration and corporate debt typically being at a slight premium to that. However, following the years of ultra-low interest rates, investors searching for yield have bid up the price of equities driving yields lower while central banks globally had to hike interest rates to fight inflation which has resulted in the higher yields on government debt.
“The Great Convergence?”
Major Asset Class Yields vs Bank Loans
Sources: U.S. Bank Loan – S&P UBS (formerly Credit Suisse); S&P Earnings Yields (equities) – Bloomberg; 3M Treasury (government bills) – Bloomberg; 30Y Treasury (government bonds) – Bloomberg; U.S. IG Corp Bonds - ICE Bank of America U.S. Corporate Index
But what does that mean for the broader credit markets? Looking to U.S. bank loans as a proxy for floating, sub-IG corporate debt in the U.S., the yield to 3-year maturity, (which is commonly quoted for broadly syndicated loans) is 8.3%. This represents a premium of at least 3% versus all the aforementioned major asset classes. Compared to the median premium over the last 30-plus years of just over 2%, this signals that broader credit returns continue to look attractive in the current market.
Regarding U.S. direct lending specifically, while data isn’t available as far back, over the last four years Cliffwater’s New Issue U.S. Direct Lending Index has averaged 1-2% premium to U.S. bank loan yields. One of the main caveats of course is that broader market conditions continue to evolve, and the underlying composition of these indices isn’t consistent over time.
Loan Yields vs “The Great Convergence” Yields
Source: ICE Bank of America U.S. Corporate Index
More broadly, this convergence challenges traditional portfolio construction and the approach to diversification. However, not everyone can be on the right side of the trade.
Investors will increasingly be required to dig deeper into the underlying fundamentals of new investments to find relative value and may have to look globally instead of just their preferred geographical markets, which is likely to be a key advantage for scaled investment managers with local expertise.
Markets Remain in Flux Post-Liberation Day
The post-Liberation Day period has resulted in a slowdown of interest rate cuts globally, a weaker U.S. dollar and riskier assets trading at levels slightly better than prior to tariff announcements; however, these are likely to be re-tested by ongoing geopolitical events and other potential volatility. GDP forecasts for the second quarter remain resilient globally, but there is recognition that most economies are still waiting for the full impact of tariffs to hit, with inflation likely to increase in the second half of 2025.
That said, while central banks are monitoring inflation carefully, tariffs themselves have more of a one-time impact, absent retaliation; banks are more focused on battling persistent inflation, which is why they will be watching jobs data closely over the coming months, with a focus on initial jobless claims and other leading indicators like Challenger job cut announcements. As exhibited in the below chart, current forecasts for some of the largest central banks (U.S., E.U., U.K., Canada and Australia) are that they will cut rates by 0.25% to 0.75% by the end of the year. The U.S. Federal Reserve most recently left interest rates on hold, with a median expectation of two cuts before year end, but of the 19 Federal Reserve officials, seven are now expecting no further rate cuts in 2025 (up from four in the previous quarter.)
Expected Rate Change by YE 2025
Source: U.S. Federal Reserve; ECB; BoE; BoC; and RBA.
Market Priced Inflation Expressions Inflation Breakevens (%)
Source: Bloomberg
U.S.
After digesting the “Liberation Day” shock on April 2, markets ended the quarter stronger than we started with leveraged credit spreads 40 to 60 basis points tighter and equities up 10.6%. The biggest hit was to the U.S. Dollar and long end of the Treasury curve with fiscal challenges highlighted as the “One Big Beautiful Bill Act” is expected to raise the primary deficit by $2.8 trillion over the next decade per the CBO. Despite the tariffs, budget bill, and geopolitical risks in the Middle East the U.S. economy remained resilient for another quarter. Job growth continued at an average rate of an added 150,000 for the quarter, while inflation continued to decline.
Looking ahead concerns around a slowing labor market are still top of mind with jobless claims increasing and “soft data” like Services and Manufacturing sector surveys pointing to less new orders and higher prices from tariffs. Additionally, the tariff relief for E.U. and China is expected to end in Q3 if no further extensions are granted. The Fed has taken this into consideration by raising their 2025 year-end core inflation forecast to 3.1% along with an increased unemployment rate to 4.5% and lower growth forecast of 1.4%. While we expect some headwinds to growth and the Fed has been in “wait and see mode,” we believe any material weakness in the job market can be reacted to quickly by easing monetary policy.
Europe
The European market is open for business. After an initial pause post “Liberation Day” the forward pipeline looks strong in both the loan and bond markets. The strong technical backdrop continues to be a highly supportive catalyst for the performance of the asset class, with the bulk of issuance volumes driven by A&E/Re-Pricing/Refinancing activity. Despite the muted levels of M&A and subdued net-new money supply, demand is strong as evidenced in the deals that have priced, which have been largely oversubscribed with margins and OID tightening from initial price talk. On the demand side, CLO formation – a key driver of loan demand – has been tracking at a record pace, while high yield fund flows have remained in positive territory after three weeks of outflows around the start of April.
Overall, the European liquid credit market has continued to rebound from early April’s trough as market sentiment has improved in-line with the direction of tariff-related news flow. Valuations have more than retraced across bonds and loans which have kept year-to-date returns in positive territory.
APAC
Consistent with other regions, the second quarter started off with muted activity post Liberation Day, but saw activity pick up across the region in the month of May and accelerated further in June. The themes of diversification and “de-dollarization” helped inflows into Asia, where in May US$15.3 billion flowed into the bond market, the largest amount since January 2016 (primarily into South Korea, Malayasia, India and Indonesia).
More broadly, the recent pick-up in credit activity was driven by refinancing and recapitalization activity followed by green shoots in M&A activity in May and June. Refinancing activity picked up across the region but was off a low base versus the high levels seen in the US and Europe over the last two years.
Consistent with previous quarters, financing volumes were largely led by commercial banks and institutional private credit providers, with the broadly syndicated loan market seeing short windows for financing opportunities. Australia, India and Japan have remained the most active markets. The big question in the second half of the year will be whether the M&A financing market continues to step up, with refinancing activity likely to remain elevated subject to material geopolitical impacts.
Conclusion
The question of which asset class will deliver the best risk-adjusted yield over the next two years and beyond will likely be a daily debate over the coming quarters. Geopolitical activity, first and second order tariff impacts, openness of equity capital markets, geographic preference, level of focus on diversification, private equity dry powder, path of interest rates, the amount of capital in credit markets and other factors are likely to be the key drivers to help answer that question.
Just as computers can help humans come up with new solutions for games like Go, traditional assets classes and alternative ones can be combined in portfolio construction to seek better risk- adjusted returns.
For this quarter’s Global Credit Monitor, we interviewed Michael Dennis and Matthew Theodorakis, Co-Heads of European Direct Lending in the Ares Credit Group, about top-of-mind market trends and themes.
Michael Dennis
Co-Head, European Direct Lending
Matthew Theodorakis
Co-Head, European Direct Lending
Q: A lot of people have argued recently that in the years since the GFC, when private credit has gone mainstream, there has not been a sustained recession that the asset class has had to weather. Do you think private credit is a cycle-tested asset class?
Matt: Ultimately, it depends on each manager’s experience and tenure, but from our perspective, private credit is a cycle-tested and resilient asset class. We launched our European Direct Lending business in 2007, shortly before the GFC, and have since successfully weathered the European sovereign debt crisis, Brexit, COVID-19, and the concoction of macroeconomic shocks we’re still seeing – from the war in Ukraine to the situation in the Middle East and everything in between. There have been numerous major macro challenges throughout the 20+ years we’ve invested in Europe. Our ability to emerge from these challenges as a stronger and more successful platform is a function of our highly experienced teams with a localized investment approach, paired with diversified portfolios focused in defensive sectors like software and financial services.
Q: As the market has evolved and matured, how would you describe the long-term prospects for European credit markets, particularly in the mid-market space?
Mike: We believe the European direct lending market still has a long runway, and we remain excited about the opportunity set. This is attributable to its secular tailwinds – including the continued retrenchment of banks, recent regulatory changes, and the growing acceptance of private credit as a source of capital in less mature markets like Italy. While there are European markets in which 50-70% of transaction financing comes from private credit, there are still many areas in which that figure is in the 20-40% region, leaving plenty of room for us, as we have the necessary scale and experience of pan-European investing. Notably, there is also an increasing opportunity for larger cap transactions in Europe, which for a long time have been financed by the bank syndicates.
Q: With Ares Capital Europe VI closing at €17.1 billion, how do you maintain investment discipline in a challenging environment for deals?
Matt: Despite raising what we believe to be the largest European Direct Lending fund, while also having the flexibility to finance larger cap transactions, we remain focused on the core middle market – in which we’ve specialized since the launch of our European business in 2007. We also remain highly selective in our allocation, making commitments to between 2-5% of the roughly 1,400 opportunities we typically evaluate each year, so we’re highly judicious in how and where we deploy capital. In this environment, our selectivity rate is [currently] closer to 2.5%, which demonstrates that even in relatively challenging cycles, we maintain our discipline. Notably, this underpins the work of our 95+ investment professionals focused on, among other things, portfolio management to ensure we maintain discipline across the life cycle of each investment.
Q: Are there specific sectors or regions in Europe that you believe are particularly ripe for direct lending activity right now?
Mike: We recently opened an office in Milan, our seventh principal investment hub in Europe, in large part because we believe its direct lending market will continue benefiting from significant secular tailwinds in the years to come. Italy is home to many family-owned businesses in fragmented sectors potentially ripe for consolidation which, paired with an uptick in mid-market buyouts, makes it an appealing market right now. Having committed over €650 million in Italy in the last five years through our European Direct Lending strategy, we have grown to know many of the key stakeholders in that market – from sponsors and advisors to management teams and entrepreneurs. While we are sector-agnostic across the Continent, we typically invest in defensive, resilient sectors less likely to be affected by exogenous shocks.
Q: With a 95-strong team in Europe, what advantages does that scale give you in such a competitive market?
Matt: The main advantage of having a team of 95+ investment professionals is the ability to originate our own deals – particularly in markets where a local presence is critical – instead of depending on intermediaries. Our teams are on the ground, building and strengthening relationships of trust with management teams, sponsors, and advisors, which has given us a competitive edge since 2009, when we opened our first Continental European offices in Paris, Frankfurt, and Stockholm. This highly localized investment approach also enables us to move with greater speed and be a more flexible capital solutions provider – especially because we are often a sole or lead lender. Additionally, we have built a strong portfolio management team whose main responsibility is to closely monitor our portfolio, respond to and mitigate risk, and provide hands-on support to management teams where needed. Our scale means we are more than just a lender – we are a partner to the businesses we invest in.