With fears of a recession starting to subside, emboldened investors are starting to invest more in the lower tier of the credit markets, according to the 'Leveraged Credit Mid-Year Review and Outlook' report by Polen Capital.

There have been positive signs about the economy recently, including inflation coming down, the Fed slowing its rate increases, and the continued strength fo the labor market, said John Sherman, portfolio manager of Opportunistic High Yield at Boca Raton-Fla.-based Polen.

In addition, the high-yield and loan markets have been performing well this year. The main factor driving that success is returns in the lower tier of the credit market, which is where bonds and loans are rated B or CCC, according to Sherman.  

“There were significant losses in these areas last year as investors positioned themselves for large defaults driven by a potential recession,” he said. “Conversely, as investors are now less concerned about the economy [or] a recession, they are now less concerned about large defaults.”

If a recession were to happen, Sherman speculated it will have a mild impact given the positive employment figures.

“As long as employment stays strong, then whatever happens to the economy is going to be muted because when people have jobs, they spend money, and when people spend money, the economy ends up doing OK,” he said. “We don't have as large of a concern as the market about a near-term recession.”

The lower-rated segment of the leveraged credit market is still at the greatest risk for maturity issues, the report said. Those loans run the highest risk of defaulting. However, while the area is the most at risk, those firms have time to avoid a major catastrophe, Sherman said.

Polen has what it refers to as a maturity wall, which represents those bonds and loans that have to refinance in the next year and a half. The amount that is coming up for maturity is only about $70 billion of $3 trillion and then in 2025 it will be about $300 billion, which Sherman estimated to be only about 10% of the overall leveraged markets.

“There’s still quite a bit of runway for companies to refinance their debts, so we don’t see there being a huge maturity wall that will generate a lot of defaults,” he said.

The firm is confident that the current market trends will continue and that the risk of a wide-scale default is minimal.

“If rates stay high through 2026 and companies’ performances are weak then you could start to see some pretty material defaults,” Sherman said. “We don’t believe that is going to be the case.”

Despite the maturity risk for the lower tier, that is the area advisors and investors can find investment gems in.

“We believe that you can dig into that segment and identify a couple of opportunities,” Sherman said. “If you're very selective in investing in that area in the market, you can find some misrated bonds and loans that are rated in the lower tier that don't exhibit the same characteristics of lower tier debt.”

The report noted that falling values in the commercial real estate sector could impact corporate debt, but added that it sees this trend as temporary. 

The commercial real estate market is an area of concern because of the unwillingness of American workers to return to the office, Sherman said. It is resulting in many companies paying for underutilized and expensive office space, he said.

“We believe that fewer workers going into the office … means companies need less office space [and] means there will be an increase in empty space, which will ultimately result in several to many buildings which don't make any sense in this environment,” he said.

When making a decision on how to invest money, Sherman recommends that advisors and investors look toward secular growing businesses with lower capital intensity that generate higher free cash flows. 

“Invest in the quality part of the bond and loan markets and really avoid companies that are stagnating or declining,” he said.

Looking ahead, Sherman recommends that advisors re-evaluate their allocations between equities and fixed income. Over the past 15 years the focus was on equities because fixed income did not have any yield. Recently, that has changed.

“I would encourage advisors to take a fresh look at fixed income … and see if it makes sense to take some money off the table after a strong rally in equities and rebalance portfolios into a higher allocation toward fixed income because the forward returns look pretty rosy for fixed income,” he said.