U.S. high-yield bonds remain one of the most favored sectors of our U.S. bond strategists.
Our model predicts that the default rate for speculative grade bonds will average near 3.0% during the next year. Moody’s latest estimate for the 12-month trailing default rate is much lower at 1.7%. Our view is that the U.S. and global economies will continue to expand (and recession will be avoided) over at least a one-year investment horizon. In this case, default losses could remain less than that projected by our model which is calibrated to pre-crisis macro factors. The current cycle could see the default rate move lower still given the scope of deleveraging that followed the financial crisis and Great Recession. Corporate balance sheets are in excellent shape, and there is still an ample cash cushion available to fund operations in the event of a growth setback.
We continue to monitor three key factors for evidence of a turn in default risk: our Corporate Health monitor, bank lending standards, and Fed policy. None of these yet signal cause for concern.
Other measures of credit market excess bear watching as well: investor use of leverage is rising; the covenant quality of high-yield bond issuance has begun to erode; valuation is compressed; and fund flows into corporate bonds have been firm. In aggregate, these measures are emblematic of the late stages of the credit cycle, but have room to deteriorate much further before the cycle ends.
Bottom Line: Continue to overweight high yield bonds within a U.S. fixed income portfolio.
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