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.

Counter-intuitively, Fed rate cuts harm Business Development Companies (BDCs). Because their loans are floating-rate, cuts directly reduce portfolio yield. This shrinks the buffer available to absorb credit losses and threatens their ability to cover dividend payments, creating a dual pressure on performance.

Default rates are not uniform. High-yield bonds are low due to a 2020 "cleansing." Leveraged loans show elevated defaults due to higher rates. Private credit defaults are masked but may be as high as 6%, indicated by "bad PIK" amendments, suggesting hidden stress.

The credit market appears healthy based on tight average spreads, but this is misleading. A strong top 90% of the market pulls the average down, while the bottom 10% faces severe distress, with loans "dropping like a stone." The weight of prolonged high borrowing costs is creating a clear divide between healthy and struggling companies.

The increase in Payment-In-Kind (PIK) debt to 15-25% of BDC portfolios is not a sign of innovative structuring. Instead, it often results from "amend and extend" processes where weakened companies can no longer afford cash interest payments. This "zombification" signals underlying credit deterioration.

A credit rating is just a starting point. Crossmark's Victoria Fernandez uses an Alcoa example to show how their independent balance sheet analysis revealed the company could still service its debt, allowing them to hold a downgraded bond to maturity and avoid realizing a significant loss.

Aegon's Global Head of Leverage Finance, Jim Schaefer, shares a critical heuristic: once a leveraged loan's price falls below the 80-cent mark, it has a high probability of entering a formal restructuring. This price level acts as a key warning indicator for investors, signaling imminent and severe distress.

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.

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.