There is a growing risk of downgrades in the high-grade market. The minimal yield premium for a single-A rating over a triple-B rating incentivizes higher-quality companies to increase leverage, potentially leading to a wave of downgrades as issuance ramps up.

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 market is not heading for a 2008-style crisis with massive default spikes. Instead, it will experience a sustained period of 3-5% default rates for several years. This cumulative "slow burn" will be painful as many over-leveraged companies, financed in a zero-interest-rate environment, face restructuring.

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.

The high-yield bond market is now nearly 60% BB-rated, a significant quality improvement over the last decade. Risk has instead concentrated in the lower-quality, B-rated leveraged loan and direct lending markets, making high-yield spreads an unreliable gauge of overall credit stress.

The common practice of bifurcating credit portfolios into 'investment grade' and 'high yield' is an artifact of historical benchmarks and institutional mandates, not an economically optimal approach. A purely systematic view would blend them based on risk characteristics.

The public high-yield market's improved quality is partly because the riskiest companies migrated to private markets. These lower-quality borrowers moved to private credit for easier access to capital, concentrating default risk in that less-regulated space.

The high-yield market's credit quality is at an all-time high, not due to broad economic strength, but because of a massive influx of 'fallen angels.' Downgrades of large, formerly investment-grade companies like Ford and Kraft Heinz have structurally improved the overall quality of the index.

A significant shift in corporate finance strategy has occurred: companies no longer universally strive for an investment-grade (IG) rating. Many firms, including 'fallen angels' downgraded from IG, are content to operate with a high-yield rating, finding the higher borrowing costs acceptable for their business models.