Investors are moving into a later stage of the cycle where portfolio quality matters more than expansion, according to KKR’s High-Grading Outlook for 2026.

A central issue is that the cost of moving into higher-quality assets is unusually low. The report shows that the valuation premium for high-quality global equities stands at about 17%, close to its lowest level in nearly eight years. High-quality stocks, defined as companies with high return on equity, stable earnings, and low leverage, are trading at a narrower premium than in much of the past decade.

Credit markets show a similar pattern. The spread between AAA- and BBB-rated US corporates has compressed to levels last seen in 2021. According to the report, this means investors can materially improve credit quality without incurring significant spread penalties, reducing the friction cost of portfolio repositioning.

The outlook does not call for a pullback from deployment. Instead, it expects economic growth in 2026 to remain strong enough to allow portfolio adjustments without sacrificing return potential. The authors note, however, that some of the expected upside from the productivity cycle has already been pulled forward into asset prices.

Default expectations are rising, but the report frames this as normalisation rather than distress. Par-weighted US high-yield default rates stood at about 1.2% as of September 2025. The outlook projects defaults rising towards a five-year average of around 2.5%, still well below levels seen during the global financial crisis and the dot-com downturn.

Credit returns are also expected to moderate as losses normalise. The report embeds assumptions of higher default rates and lower recovery rates, with recoveries projected at 42%, compared with roughly 57% in recent quarters. Even so, expected high-yield returns remain positive, supported by elevated all-in yields.

The authors argue that these conditions favour a shift away from broad beta exposure and towards portfolio resilience. This includes tighter position sizing, more conservative leverage, and greater emphasis on proprietary origination, particularly in credit strategies. The report also highlights operational improvement and employee ownership as potential sources of incremental upside.

Beyond assets, the outlook extends the concept of high-grading to counterparties. It recommends reassessing exposure to financial institutions, asset managers, and vendors, reflecting the growing importance of counterparty strength later in the cycle.

The report concludes that 2026 is not a year to exit risk markets, but a year to be more deliberate. With upgrade costs low and defaults expected to normalise rather than spike, investors have an opportunity to improve portfolio quality before conditions become less forgiving.

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