Pimco warns a wave of defaults is coming for low-quality borrowers

Pacific Investment Management Co. (Pimco) has issued a warning about an emerging 'credit loss cycle,' stating that heavy investment in artificial intelligence could exacerbate economic inequalities and lead to significantly higher losses for lower-quality borrowers. In their latest annual secular outlook report, Pimco analysts Richard Clarida, Andrew Balls, and Daniel Ivascyn highlighted that defaults are reasserting themselves, particularly in leveraged and private direct lending sectors. The firm observed that high-grade credit spreads remain near three-decade lows, while demand for riskier debt persists despite recent global bond selloffs, driven by higher yields. Pimco described this backdrop as 'complacency' rather than strength, noting that AI disruption may disproportionately affect highly leveraged companies in the 'old economy.' The report also pointed to rising instances of debt maturity extensions and 'payment-in-kind' structures, signaling a more severe default cycle than past experiences. Pimco expects AI-driven productivity gains to ease wage pressures and inflation, but geopolitical shocks and supply chain adjustments could offset these effects. Central banks are expected to maintain aggressive measures to anchor inflation expectations over the next five years, with Pimco recommending intermediate-dated sovereign bonds (5-10 years) for potential income and capital gains in a downturn. The firm acknowledged that while elevated debt and deficits limit fiscal flexibility, a US fiscal crisis is not imminent due to the dollar’s reserve status. However, they cautioned that current policies remain unsustainable. Pimco’s flagship $228 billion Income Fund has outperformed peers, returning 0.3% year-to-date and 7.8% over the past 12 months, reflecting its strategic positioning amid market volatility. Historically, US recessions have occurred in 69% of five-year periods since World War II, and Pimco anticipates central banks will use their rate-cutting capacity more aggressively in future downturns. The firm also advised diversifying with non-US debt to mitigate risks tied to the US fiscal trajectory.