US Corporate High Yield Credit

Shortly after US Corporate High Yield credit spreads reached their tightest levels, investors are now worried that the credit cycle is turning, evident in last year’s abrupt about- face in spreads. Investors are aware that the economy remains the most important driver of defaults but appear to underestimate forecasts of US GDP growth remaining above trend. Though a partially inverted yield curve is raising grave concerns, other leading indicators of recession such as the Conference Board Leading Economic Index stand at levels that are more consistent with continued economic growth than an imminent descent into recession.

Since high yield firms generate almost three-fourths of their sales domestically.  Leading indicators of credit risk remain equally benign. Moody’s Liquidity Stress Index, which rose six months before the last default cycle, today stands below its long-run median and at a level that has been lower only 17% of the time historically. Meanwhile, the distress rate remains at innocuous levels today despite recent spread widening. Finally, tightening in bank lending standards has historically forewarned of higher future defaults, yet today banks continue to ease standards.  The market seems to be discounting defaults based on the excess spread over actual default losses that investors have demanded historically.

Market fundamentals seem less compromised than current spreads suggest. New issuance by lower-rated companies remains low relative to history. At the same time, the modest uptick in new issuance used for balance sheet- weakening M&A activity remains well below the levels seen prior to the financial crisis.