How close are we to the end of the credit cycle?

With corporate bonds likely to offer little more than their coupon return, is it time to short the asset class?

14 November 2014

SIGMA Credit Risk Premium Group

Multi Asset

Investors in fixed income should bear in mind an observation from the veteran investor Howard Marks: “Rule number one: Most things will prove to be cyclical. Rule number two: Some of the greatest opportunities for gain and loss come when other people forget rule number one .”

 

History suggests that credit markets remain in the expansionary phase for several years before policy tightening feeds through to a deterioration in credit spreads. However, this cycle could be different.


Over the last couple of years, global credit spreads have compressed significantly making credit less attractive. Looking ahead, a strategic allocation to the credit risk premium is likely to generate little more than carry – that is, the coupon return obtained from simply holding the individual bonds.

If the spread between yields on corporate bonds and government bonds continues to grind tighter, credit is likely to offer an opportunity for flexible investors to benefit from this overvaluation. Our attention has, therefore, turned to the difficult task of assessing how close we are to the end of the current credit cycle and to answer the question: “Should we go short?”

To answer this question we need to understand the credit cycle and its current evolution. The greatest opportunities may come to those who can apply Howard Marks’ insight to credit markets by realising that they are indeed cyclical.

We analysed US credit cycles from the early 1980s onwards and found that previous credit cycles lasted an average of nine years. To gain greater insight, we separated the credit cycle into three phases: downturn, repair/recovery and expansion. We can track these phases using credit spreads and other measures of economic and corporate health. If the past serves as a guide, then there could be another two years or more before the current cycle comes to its natural end.

Our qualitative and quantitative assessments show that the current credit cycle is in an expansion phase, where the economy is on a firmer footing and monetary policy is biased towards tightening. While there is no doubt that volatility is currently extremely low across financial markets, this is not unusual within credit for this phase of the cycle. Generally, stable credit spreads make this environment appear ideal for harvesting carry – but for how long will this be the case?

The interest rate cycle plays a pivotal role in the rotation between phases of the credit cycle. Based on the current pricing of interest rate markets, monetary policy is expected to begin to normalise from 2015. History suggests that credit markets remain in the expansionary phase for several years before policy tightening feeds through to a deterioration in credit spreads. However, this cycle could be different from past cycles, as we have had a prolonged period of low interest rates and an unprecedented amount of monetary stimulus by central banks, creating a market dynamic that has not previously been observed.

With this in mind, we think it is prudent to focus on those catalysts that could derail credit markets before the natural end of the current credit cycle. One such risk is that the Federal Reserve under-reacts to changes in the economy and is forced to act aggressively to regain control or the appearance of control.

Please find the full research paper below.

Important Information: The views and opinions contained herein are those of the author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. It is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a reliable indicator of future results. The value of an investment can go down as well as up and is not guaranteed. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Schroders has to its customers under any regulatory system. Regions/ sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this material include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change.  To the extent that you are in North America, this content is issued by Schroder Investment Management North America Inc., an indirect wholly owned subsidiary of Schroders plc and SEC registered adviser providing asset management products and services to clients in the US and Canada. For all other users, this content is issued by Schroder Investment Management Limited, 31 Gresham Street, London, EC2V 7QA. Registered No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.