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.

The term "middle market" is too broad for risk assessment. KKR's analysis indicates that default risk and performance dispersion are not uniform. Instead, they will be most pronounced in the lower, smaller end of the middle market, while the larger companies in the upper-middle market remain more resilient.

The primary threat to the high-yield market isn't a wave of corporate defaults, but rather a reversion of the compressed risk premium that investors demand. This premium has been historically low, and a return to normal levels presents a significant valuation risk, even if fundamentals remain stable.

Recent "canary in the coal mine" cases like First Brands, often blamed on private markets, were not PE-owned and were primarily financed in liquid markets. In fact, it was private credit firms pushing for deeper diligence that exposed the issues, strengthening the argument that private credit offers a safer way to access the asset class.

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.

Recent credit failures and frauds are not 'systemic' risks that threaten the entire financial system's structure. Instead, they are 'systematic'—a regularly recurring behavioral phenomenon. Good times predictably lead to imprudent lending, creating clusters of defaults. The problem is human behavior, not a fundamental flaw in the market itself.

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.