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?
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.