There's a quiet irony unfolding in credit markets. Investors who built portfolios around the logic that diversification requires owning more (more asset classes, more positions, more exposure) may find their bond allocations are doing the opposite.

One reason might be hiding in plain sight and that’s the hyperscalers. Over the past two years, the world's largest technology companies have become some of the most prolific issuers of corporate debt, tapping bond markets to finance their AI infrastructure buildout. The five largest US technology companies have committed to capital expenditure of approximately $800 billion, according to Morgan Stanley Research estimates¹.

The result may be the beginning of a structural shift in what corporate bond indices actually contain. Those tech giants already account for a small but growing share of some major bond indices (figure 1). That means an investor holding a passive S&P 500 fund and a passive corporate bond index fund is no longer holding two distinct risk exposures. They are holding equity risk in the S&P 500, and then re-buying a slice of the same companies through the bond market. In turn, concentration risk doesn't dissipate, it might even be doubling up. For investors relying on fixed income for diversification, this matters.

Figure 1: Hyperscalers’ share of investment grade index vs S&P 500

Source: Morgan Stanley Research, ICE Baml, Bloomberg

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The potential problem with the passive playbook in credit

The logic of passive investing for some investors seems straightforward in equities, when considering market-cap-weighted exposure and low cost. In credit, the same logic produces a different outcome.

A market-cap-weighted bond index allocates more to the largest issuers, which means the most indebted companies get the biggest allocations. As AI-driven capital expenditure drives hyperscaler debt issuance higher, that concentration may compound over time. Meanwhile, the middle of the credit market – smaller and medium-sized issuers, which tend to be under-researched and less picked-over – will likely get proportionally less attention.

This is where the opportunity lies, we think. Smaller and mid-sized bond issuers typically offer wider spreads relative to their fundamentals precisely because fewer managers look at them closely. Large funds, anchored to the index, are less inclined to meaningfully pursue this segment because their size typically forces them into the broad market. Nimbler, bottom-up managers tend to have more flexibility.

We believe the distinction between a manager that allocates based on macroeconomic forecasts and one that allocates based on issuer-level fundamentals also matters more in the current environment. The last several years have exposed how unreliable macro forecasting can be, with inflation surprising to the upside, central banks reversing course dramatically and geopolitical shocks rewriting energy price assumptions. We think a portfolio construction process that depends on getting those macro calls right carries more risk than it might seem.

A more likely route to genuine diversification in fixed income

True income diversification means accessing return streams that are genuinely distinct (across issuers, sectors, geographies and parts of the capital structure) rather than simply owning more of what the index already holds.

In practice, this means being unconstrained with no systematic bias towards any sector or region, in our view. It has flexibility potential to move up and down the capital structure, from investment grade to high yield, depending on where the margin of safety seems most compelling.

It also means a focused portfolio. A manager holding 100 high-conviction positions, each selected because the spread compensates appropriately for the fundamental risk, operates differently to one holding 1,000 positions that broadly mirror the index. Conviction in well-researched ideas is not the same as concentration risk, we think.

It might also mean being willing to do less when conditions warrant. In environments where credit spreads are tight and valuations leave little margin for error (as they were for much of 2025 and 2026), the right answer for a fundamental credit manager might be to reduce net exposure, play defense, and wait for better opportunities rather than buy the market regardless.

What this means for building income allocations

Three questions worth asking of any fixed income allocation:

• Does it genuinely diversify away from equity risk? If the underlying holdings overlap meaningfully with what the equity portfolio already owns, particularly in mega-cap technology, the answer is most likely, no. A truly diversified credit allocation should bring return streams that behave differently from equities, particularly during drawdowns
• Is the manager constrained by size? The largest flexible bond funds run hundreds of billions across thousands of positions. At that scale, meaningful exposure to smaller, under-researched issuers is structurally unlikely. Smaller, more focused funds are more likely to go where the large ones cannot
• Is the process forecast-dependent? A manager whose portfolio construction depends on being right about the direction of rates, currencies or economic growth is taking a different kind of risk, one that has proven to be tricky in this environment. We think a bottom-up approach, grounded in issuer fundamentals and margin of safety, is likely more repeatable across market cycles

1. https://www.morganstanley.com/insights/articles/ai-infrastructure-stocks-opportunity