The option-adjusted spread declined 41 basis points in February and currently rests at 361, just 21 basis points above our multi-year spread target of 340. Our U.S. Bond Strategy service recommends maintaining overweight allocation to high yield bonds.
There are certainly budding signs of deteriorating credit quality in the high-yield space: our Corporate Health Monitor appears poised to cross over into deteriorating health territory, covenant quality remains weak and there has been a surge in payment-in-kind issuance. For now, however, these trends are in their very early stages and corporate balance sheets are starting from a very healthy base.
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Moreover, a worsening in credit quality is only one of several conditions usually required to mark the end of a cyclical bull market in spreads. Typically, spreads only begin to widen once the Fed has tightened policy into restrictive territory. An additional catalyst, such as a tightening in lending standards, is then usually required to prompt an upswing in defaults.
The 12-month trailing default rate fell to just 1.78% in January, and our model projects only a slight increase over the first half of this year before it levels-off. Investors remain well compensated for bearing this default risk, as the default-adjusted spread has just recently dipped below its historical average.
Zero-bound rates will continue to make spread product a hot commodity over at least the next year. A more significant undershoot of the historical average default-adjusted spread, down perhaps to the 190 level that prevailed during the latter part of the previous credit cycle, seems entirely possible.
