We Would Buy All the Corporate Bonds the IMF Wishes to Sell

Our U.S. Corporate Health Monitor remains firmly in improving health territory, which historically lines up very well with periods of corporate bond outperformance. Apart from corporate sector fundamentals, our default rate outlook also continues to support an overweight allocation to credit risk.

Our model suggests that the default rate will continue to trend lower during the next twelve months:

One of the key parameters in our default rate model is the willingness of the banking sector to extend credit to the business sector. Banks have steadily eased their lending standards on commercial and industrial loans in all but one quarter since early 2010. In the past three major default cycles, tighter lending standards have been a strong predictor of an escalation in corporate default activity with a lead time of 9 to 18 months. In turn, bank lending standards are guided by monetary policy and tend to tighten in concert with a move by the Fed into restrictive monetary territory.

Tighter financial conditions are a risk to the corporate sector especially if they coincide with a period of heavy refinancing requirements. The refinancing wall comes into play beginning in late 2016 through 2018. The Fed will certainly be in the process of tightening monetary conditions during this period, but this will only present a problem for corporate debt issuers if the Fed is purposefully pushing its target rate into restrictive territory in an effort to slow economic growth and curb an inflation threat. Yes, another default wave will eventually arrive, but this does not seem likely within the next three or four years and certainly not by mid-2015 as the IMF predicts.

Bottom Line: Non-financial corporate sector fundamentals continue to improve. The default rate is headed lower on a one-year horizon and probably on a three-year horizon as well. We would buy all the corporate bonds the IMF wishes to sell.

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