While lower rates seem beneficial for leveraged companies, the context is critical. The Federal Reserve typically cuts rates in response to a weakening economy. This economic downturn usually harms issuer fundamentals more than the lower borrowing costs can help, making rate-cutting cycles a net negative for high-yield credit.

Oaktree's co-CEO highlights a critical flaw in applying venture logic to debt. In a diversified equity portfolio, one huge winner can offset many failures. In a diversified debt portfolio, the winner only pays its coupon, which is grossly insufficient to cover the principal losses from the losers.

While default risk exists, the more pressing problem for credit investors is a severe supply-demand imbalance. A shortage of new M&A and corporate issuance, combined with massive sideline capital (e.g., $8T in money markets), keeps spreads historically tight and makes finding attractive opportunities the main challenge.

History shows that markets with a CAPE ratio above 30 combined with high-yield credit spreads below 3% precede periods of poor returns. This rare and dangerous combination was previously seen in 2000, 2007, and 2019, suggesting extreme caution is warranted for U.S. equities.

The CCC-rated segment of the high-yield market should not be treated as a simple down-in-quality allocation. Instead, it's a "stock picker's" environment where opportunities are found in specific, idiosyncratic situations with high conviction, such as a turnaround story or a mispriced part of a company's capital structure.

The market is focused on potential rate cuts, but the true opportunity for credit investors is in the numerous corporate and real estate capital structures designed for a zero-rate world. These are unsustainable at today's normalized rates, meaning the full impact of past hikes is still unfolding.

Despite compressed spreads and improved market access, credit markets are not complacent. Pricing for the most vulnerable emerging market sovereigns still implies a significant 17% near-term and 40% five-year probability of default. This is well above historical averages, signaling lingering investor caution and skepticism about long-term stability.

For 40 years, falling rates pushed 'safe' bond funds into increasingly risky assets to chase yield. With rates now rising, these mis-categorized portfolios are the most vulnerable part of the financial system. A crisis in credit or sovereign debt is more probable than a stock-market-led crash.

The modern high-yield market is structurally different from its past. It's now composed of higher-quality issuers and has a shorter duration profile. While this limits potential upside returns compared to historical cycles, it also provides a cushion, capping the potential downside risk for investors.