What the bond market knows that equity investors may be missing

Fixed income rarely generates the same excitement as a soaring stock or the latest AI winner - but that is precisely the point. 

Credit investors are not paid to dream about what could go right. They are paid to work out what could go wrong, and right now, the bond market is flashing some signals that equity investors may want to pay attention to. As Daintree Capital's Brad Dunn puts it:

“Successful investing is about finding the safest path to your destination, even if it is not always the fastest or most exciting.”

In this Q&A, Dunn explains why parts of the credit market look stretched, where investors are still being adequately rewarded for risk, and why the enormous spending behind the AI boom is attracting scrutiny from lenders. 

He also reveals how Daintree is positioning its portfolio as financial conditions remain tighter than buoyant equity markets might suggest.

Question the narrative

The fundamental difference between equity and credit investing starts with the payoff. Equity investors can participate in enormous upside if a business succeeds. For a lender, the upside is capped, making the borrower's ability to repay its debt paramount.

That creates a very different mindset for Dunn and the Daintree team.

“It forces us to constantly question the narrative. Credit investors need to be thinking two steps ahead of the dominant market themes.”

Artificial intelligence provides a timely example. While equity investors are focused on the potentially enormous earnings opportunity, Daintree is considering how much capital will be required to build the infrastructure supporting that growth and, importantly, where that money will come from.

“Excessive debt (regardless of the purpose) has so often been the downfall of great investment ideas,” Dunn says.

Where investors aren't being paid enough

That focus on downside risk is particularly relevant when the additional return available from taking more risk becomes too small.

Dunn believes this is happening in parts of the non-investment-grade credit market. Once the bonds most likely to default, those rated CCC to C, are removed, the spread premium over investment grade credit has compressed materially. Investors are therefore receiving relatively little additional compensation for moving into the “junk bond” market.

Daintree is also watching private credit, with Dunn highlighting funding stress in some parts of the ecosystem, particularly property development.

When assessing individual opportunities, Daintree groups potential red flags into four broad categories: governance, strategy, management and financials. The team considers these factors individually, but also examines how they interact over time.

“In our experience, when several categories are underperforming simultaneously, credit underperformance follows.”

The debt behind the AI boom

AI may offer enormous growth potential, but Dunn sees an important distinction between a compelling equity narrative and a compelling credit investment.

For equity holders, today's spending can be justified by the prospect of substantial profits tomorrow. Credit investors require greater certainty about cash flow because it is central to their returns and to the borrower's capacity to service debt.

“In today’s fast-paced market, and across the AI complex right now, there is a discomfiting dissonance between planned expenditure and future cashflows that leaves us feeling cautious.”

Dunn believes enthusiasm around AI has almost certainly encouraged some investors to overlook traditional lending disciplines. He points to increasingly complex funding arrangements, including special-purpose funding vehicles, private credit involvement, and multi-decade leasing structures.

That complexity does not necessarily make an investment unattractive, but it raises the importance of understanding exactly where the risks sit.

Daintree's benchmark-unaware approach means it does not need to participate, even as issuance grows. Dunn notes that bonds issued by hyperscalers and other large AI-connected companies have noticeably underperformed despite broader credit spreads holding up well.

With conviction currently low, Daintree is watching from the sidelines.

What bonds are telling investors

That caution extends beyond individual AI-related issuers. Dunn says the cost of insuring technology debt through credit default swaps has been increasing, signalling concern about the pace at which businesses traditionally associated with strong cash flows are accumulating debt.

At the same time, long-term government bond yields have risen across developed markets. Daintree attributes this partly to inflationary forces, including AI capital expenditure and energy supply disruptions, alongside large fiscal deficits generating substantial government bond issuance.

“Even though equity markets are at or near record highs in some cases, the bond markets are saying that financial conditions are tighter than what equity indices alone might suggest.”

That does not mean Dunn sees credit as broadly unattractive. He believes investors are still being sufficiently compensated in higher-quality areas where default probabilities remain very low, with investment grade credit expected to perform solidly across most environments.

The equation becomes less attractive further down the credit spectrum, while Dunn argues the expansion of private credit has also reduced some of the transparency and market-based information traditionally used for price discovery.

Getting paid without reaching for risk

Daintree's recent investment in Canberra Data Centres illustrates how this philosophy translates into portfolio decisions.

The company has established corporate and government customers and has recently secured large contracts with global companies. Daintree was already a lender through subordinated notes when Canberra Data Centres issued senior secured, investment-grade bonds for the first time.

Despite the new securities offering a lower yield, Daintree sold its subordinated position and moved into the secured bonds.

“We wanted to remain a lender to the company, but we prefer a more senior position in the capital structure during this next phase of growth.”

It is a neat illustration of Daintree's broader approach - income matters, but not at any price. When the risk-reward equation changes, accepting a lower yield in exchange for greater protection can be the more attractive investment.