Debt Wobbles

“When you see one cockroach, there are probably more.”  Jamie Dimon, CEO JP Morgan 

This was Jamie Dimon’s response to a question last October about a failed loan JP Morgan made to Tricolor, a subprime auto lender. It turned out that Tricolor pledged the same collateral to multiple lenders and was forced into bankruptcy. That same month, First Brands Group, an auto parts supplier, collapsed amid allegations of an even larger fraud involving fake invoices, double pledged receivables, and undisclosed off balance sheet financing.   

These failures helped trigger a broader reassessment of underwriting standards across credit markets. Private credit funds were one of the few places investors could ask for their money back, and by early 2026 redemption requests began to surge.  

The pressure intensified as markets grew concerned about traditional software companies in the age of AI. It turned out that ~20% of private credit loans were tied to software, with certain funds having significantly more exposure.  

Most recently, there were two high profile cases involving NBA team owners. Mark Walter, co-founder of Guggenheim, agreed to sell his Los Angeles Lakers stake amid a federal probe into billions of dollars of previously undisclosed related party loans involving businesses and insurers he controls. Mat Ishbia, has not been forced to sell his stake in the Phoenix Suns, but his company, United Wholesale Mortgage, needed a $2 billion bailout after a poorly timed bet on interest rates.   

Taken individually, none of these incidents says much about the broader state of credit markets, especially with reported default rates still low. However, they are consistent with what happens late in a credit cycle when too much capital meets too few quality opportunities. The question is whether more cockroaches will find their way out of the cracks, and what we should do about that possibility.   

The Set Up  

It’s hard to know if more problems will emerge, but the backdrop for borrowers is becoming less forgiving. Inflation has remained above the Fed’s target since 2021, and if you believe anything that Fed Chair Kevin Warsh says, investors should be prepared for the possibility that the next move in interest rates is higher, not lower, and that the Fed’s balance sheet shrinks rather than grows.  

That would make matters only more difficult for a U.S. Government that has already run six consecutive years of deficits exceeding 5%, while carrying over $40 trillion of debt, with no slowdown in sight.    

So far, AI can’t solve these problems and is actually contributing to them. The large AI spenders have gone from using their own free cash flow, to becoming some of the largest issuers of investment grade bonds, to now using significant off balance sheet debt. On top of that, companies like Nvidia and Broadcom are providing massive financial guarantees and backstops to help finance infrastructure built around their own chips. The payoff is large, but leverage adds to the risk.    

Against that backdrop, the 30-year Treasury recently topped 5.3%, its highest yield since 2007, and remains around 5.2%.   

The Coming Credit Cycle  

At this stage in the cycle, there are only two ways to lower long-term interest rates. The first is for the federal government to show it is serious about tackling persistent budget deficits. That appears to be on neither party’s agenda.    

The second is for the Federal Reserve to establish enough credibility on inflation that long-term inflation expectations fall. That may require an interest rate hike in the spirit of Paul Volcker, who began tightening monetary policy in 1979 to finally break the inflation of the 1970s.   

If policymakers do not take inflation and deficit spending seriously, long term interest rates are likely to continue their march higher. Conversely, addressing them can create its own set of risks in the short term, even if it’s the right long-term decision. But trying to predict what a handful of policymakers will do, and how the market will respond, is a bad game to play, so we will plan for the worst and hope for the best.   

What that means is our bond portfolios remain focused on high-quality borrowers, who maintain reasonable levels of debt, strong interest coverage, and responsible managers. We’ve also kept our average maturity very short dated, so as bonds mature, we can simply reinvest at higher yields.   

The same logic applies to our equities where we continue to trim our exposure to the high-flying semiconductor sector while increasing our investments in durable, cash generating businesses at more reasonable valuations. That is not always a fun decision to make, but necessary in light of the economic backdrop.   

After a 15 year credit bull market it’s not surprising that underwriting standards get stretched somewhere. The recent cockroaches may or may not indicate a serious infestation, but we believe credit selection and proper risk management will matter a lot more moving forward.   

_{Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.}