Western Asset: Why ‘remarkable’ US credit rally still has room to run

The rally in US corporate bonds so far in 2016 has been nothing short of “remarkable” and shows no signs of slowing in the near term, with interest rate rises shelved for the foreseeable future, Legg Mason subsidiary Western Asset has said.
After a challenging start to the year, which saw US credit markets price in a non-existent recession, there has been a credit rally since mid-February which – despite a few challenges – currently shows no signs of slowing. Indeed, since February, U.S. high-yield and U.S. investment-grade^[1] markets have rallied 15.75% and 7.53% (as of July 6, 2016) respectively.
Can this continue? Michael Buchanan, Deputy Chief Investment Officer at Western Asset, believes so. Although there had been a temporary disruption in June sparked by the UK’s decision to leave the EU, Buchanan said the yields on US corporate bonds continue to look attractive against a backdrop of negative or near zero interest rates.
“We expect slow but steady economic growth and muted inflation, and although Brexit may induce a slight drag, the global recovery remains on track,” said Buchanan.
“This is thanks in large part to central bank policies that have collectively infused $14 trillion into global economies, and until said economies demonstrate the ability to sustain growth without such support, we believe central banks will continue to be accommodative. This is a positive backdrop for credit, and the credit cycle certainly has more room to run.”
The current rally has exceeded the average duration of a bull cycle but the Bank of America estimates that, thanks to negative or low rates in Europe and Asia, there could still be incremental demand for U.S. credit over the next 12 months of $300 billion-$500 billion.
Demand could remain strong thanks to the yields on offer. The US High Yield Market currently projects a yield of 7.0% (as of 31 July 2016), compared to European High Yield at 4.0%. Higher up the credit spectrum, the US Investment Grade Market currently projects a yield of 2.8% (as of 31 July 2016), versus 1.0% in European Investment Grade^[2]. Considering this, we believe the negative rate experiment could provide a strong technical boost for U.S. corporate credit.
“We don’t believe that credit cycles die of old age, rather because of overextended corporate balance sheets, or when companies become challenged to meet obligations,” Buchanan said.
“Overall credit fundamentals are more than adequate and quite strong,” he said. “We see little evidence that balance sheets are over-levered and see ample evidence of significant liquidity to meet obligations. This supports the argument that the market remains in a favourable stage of the credit cycle.”
[1] According to Western Asset’s latest note, entitled ‘Standing Our Ground: There continues to be value in credit”, investment grade credit markets in the US have rallied by 7.53% between 11/02/16 and 06/07/16.
[2] Source: Barclays Capital as at 31/07/16.