The credit cycle still has room to run

While there's no arguing that the current credit cycle has outlasted the duration of a typical bull market, we don't believe that credit cycles die of old age.

Rather, they end because corporate balance sheets become overextended and companies become challenged to meet current obligations. In general, we see little evidence that balance sheets are overlevered and ample evidence of adequate liquidity to meet obligations.

One key indicator that a credit cycle has moved into the downturn stage is an above-average default rate—and it's worth noting that the trailing 12-month default rate for high-yield debt crossed into above-average territory in 2016. But those defaults have been highly concentrated in certain industries: Excluding the energy and metals and mining segments of the market, the trailing 12-month market default rate was only 0.70%, which is well below the long-term average. The commodity industries, even with oil trading in the $50 to $60 range, are under a great degree of stress and are at a different point in the credit cycle than most other industries. Most other industries' fundamentals remain solid, supporting the argument that the market remains in a favorable stage of the credit cycle.

We do believe this credit cycle is different. More than anything, the severity of the financial crisis in 2008–2009 was a key driver in changing corporate behavior and producing more restrictive regulations. Corporations today are much more conservative in managing their balance sheets and cost basis. Case in point, the number of leveraged buyouts (LBOs), historically a meaningful contributor to rising defaults when markets turn south, has been relatively small. Post-crisis regulations restrict underwriters from arranging financing for the purpose of an LBO if the resulting leverage level for the company exceeds certain thresholds. We simply haven't seen the kinds of aggressive acquisitions that have typically been harbingers of a rise in defaults.

So then where are we in the credit cycle? The reality is that we're all over the map. As we've seen, the commodity industries continue to face significant pressures; the healthcare industry, on the other hand, has experienced a tremendous amount of growth since the passage of the Affordable Care Act, and the industry as a whole is in the expansion phase. The banking industry, meanwhile, suffered severe stresses during the financial crisis. Banks have spent years reducing leverage, improving their balance sheets, and enhancing liquidity. As a result, U.S. banks today are fundamentally stronger than at any time in the past 50 years—driven by regulatory changes that make them more utility-like—and are definitively in the recovery phase. Additionally, President Trump and the Republicans' deregulation agenda may loosen some of the restraints banks face and fuel further growth in that sector.

Given our view that fundamentals, in general, remain positive, we believe that spreads (the difference in yield, in this case, between corporate and U.S. Treasury debt) could tighten to below-average levels. Notably, we also see potential for further compression in the energy and commodities-based industries; we believe the risks are more than reflected in spreads, representing potential value in these areas.

Moreover, there are some powerful technical tailwinds behind the U.S. debt markets. Of the more than $80 trillion in global debt, almost 75% of it trades at a 1% yield or lower, including nearly $20 trillion that offers a negative yield.¹ This fact alone could support further spread compression for the U.S. corporate credit markets. While our investment recommendations are based on thorough fundamental and relative value analysis, we believe the negative rate experiments of foreign central banks could provide a strong technical impetus for U.S. corporate credit.

We see two major risks to our base-case view on corporate debt. The first is the possibility of the global economy slipping into recession. We find this generally unlikely, given that the global economy has not yet built up the excesses that would normally propel it into recession, and because central banks stand ready to provide further accommodative monetary policy support to boost economic activity. The more likely risk is that economic data surprises to the upside, prompting the U.S. Federal Reserve to raise rates at a faster clip than investors anticipate. In any case, if higher rates are predicated on stronger economic conditions, which we believe they will be, it's reasonable to expect that corporations would benefit from such an environment. While quantitative easing and other monetary policy tools have aided—and most likely extended—the current credit cycle, we believe fundamentals are generally still strong and that this bull cycle has room to run. While we believe it's prudent to actively tailor risk around changing market conditions, we continue to believe there's value in credit, even eight years into the current bull market.

1 Western Asset Management Company, as of 3/1/17.