The 2003-07 credit cycle provides an instructive template on how the current cycle may eventually play out.

C orporate credit spreads narrowed throughout 2006 even after the Fed had boosted its target lending rate above equilibrium. Spreads continued to trend lower in early 2007 even after our Corporate Health Monitor moved into “Deteriorating Health” territory. While these two factors together created a formidable headwind for credit, spreads still needed a catalyst before reversing direction.

That catalyst appeared in mid-2007 as the Senior Loan Officer survey revealed that banks were actively tightening lending standards. The supply of credit to low-quality firms was shut off and the market quickly handed high-yield investors a painful setback. High-yield bonds underperformed the Treasury market by nearly 2000 basis points between June 2007 and March 2008 as the index spread widened to 830 basis points.

Such a turning point is unlikely to materialize soon. Monetary policy is exceptionally easy and our measure of non-financial corporate sector health remains in improving health territory, although admittedly is showing some signs of decay. A further deterioration in corporate health will be an important signal for caution. That said, it will not be enough on its own to end the rally, especially given the strong starting point of corporate balance sheets. Therefore, spreads are likely to trend lower until both the Fed and the banking sector are tightening credit conditions. This point is probably several years away.

Bottom Line: The rally in high-yield has further to go, despite the dramatic narrowing in spreads to post-crisis lows.