Where are we in the credit cycle and how long do we have before it turns? This is a question we often get asked by investors. Any serious analysis of this topic requires an understanding of the long term behaviour of interest rates, central bank policy, agency credit ratings, corporate balance sheet fundamentals and credit spread cycles. Here we highlight some of these metrics and conclude that we are currently somewhere between mid and late cycle – the current cycle probably still has some way to run.
Traditional decompositions of the credit cycle define the following four phases: (i) downturn, (ii) repair, (iii) recovery and (iv) expansion. Each of these phases can last a while and the transitions between phases aren’t always clear cut. Our qualitative and quantitative analysis suggests that we are currently in the expansionary phase in the US and still in the latter stages of the recovery phase in Europe.
The long term ratings backdrop is one of ongoing credit quality deterioration in the global investment grade issuer universe. Figure 1 shows that there has been a consistent lowering of the average credit quality – that is, a greater number of BBB rated issuers – for the investment grade corporate issuer universe, especially since the global financial crisis began. In 1989 only forty percent of all Moody’s rated investment grade corporate issuers were low rated (i.e. BBB or A). Today that figure is almost ninety percent!
Delving deeper and splitting by region, we see that the majority of this deterioration has come from GBP and EUR bonds. Figure 2 demonstrates the average bond quality of the BAML global investment grade index since 2000. The pace of deterioration picked up sharply during the crisis.
Interestingly, the average bond quality of the equivalent index in the global high yield universe over the same time period actually shows an improvement – see Figure 3. This is because the high yield universe has over time been comprised of an increasing number of fallen angels. At the same time, the number of CCC rated issuers coming to the high yield market has fallen sharply. It is also worth noting that these high yield ratings may have been somewhat flattered by the fact that some lower rated issuers have been resorting to the loan market to raise financing – here we have only analysed the high yield bond market in isolation.
Whilst quantitative easing remains supportive of the credit cycle – by lowering rates and increasing the demand for credit – we also note that it has resulted in a low number of defaults over the last few years. Figure 4 illustrates global high yield default rates since 1998.
Looking at aggregate fundamental credit trends in the US and in Europe – for example, revenue, EBITDA, interest coverage and net leverage – we conclude that corporate balance sheets still look to be in decent shape at this stage of the credit cycle. But how should one relate ratings and corporate fundamental health to credit spreads? Each phase of the credit cycle is associated with corresponding trends in credit spread movements – the downturn is clearly associated with spread widening, the repair and recovery phases with spread tightening, and the expansion phase with spread stability. It is instructive to analyse spread cycles to better understand credit cycles.
Figures 5 and 6 plot credit spreads over the long term in investment grade and high yield, respectively. In each case, we show two separate measures of the index spread – an unadjusted measure and another that has been adjusted by duration and credit rating factors. We see from Figure 5 that the adjusted measure in investment grade is slightly rich relative to its average value during the years preceding the beginning of the last crisis. The equivalent graph for high yield shows that neither measure is rich – in fact, high yield spreads are somewhat cheap relative to their pre-crisis fair-value line.
On aggregate, whilst spreads may seem slightly rich in investment grade credit, we have to be cognizant of the fact that monetary policy still remains supportive of credit as an asset class. This situation can certainly continue for a while yet.
Another interesting metric to look at is spread dispersion. Figure 7 shows the volatility of spreads, or their dispersion, across investment grade index constituents in any given month. Spread dispersion is currently at a decade low, which implies that credit investors are not being paid for issuer differentiation, or to take on the inherent jump or default risks associated with some of the riskier names. An active credit portfolio management process would look to hold quality names at this point in the spread dispersion cycle, and to then assess and buy some of the riskier ones as and when the compression in spread volatility begins to unwind.
Next we look at the bias in spreads relative to the average spread on any given day. This measure is known as the skew. A positive bias (or skew) would indicate that there are more names with spreads in the cheap tail of the spread distribution than there are in the rich tail. Figure 8 shows the skew in adjusted spreads in the investment grade space since 1997 and highlights that it is currently quite positive. A passive investment process would be forced to hold these higher spread tail names, whilst an active management process would weed out those that are “cheap for a good reason”.
Our final piece of long term spread analysis involves looking at what investment grade credit pays passive investors through a full cycle. In Figure 9, we look at the returns of passive investment grade portfolios formed each month and held for seven years – seven being the length of an average credit cycle. We find that the average annual credit spread return – i.e. the return in excess of treasury returns – of all the portfolios formed between 1997 and September 2008 was merely 20 basis points. The downturn in 2008/09 greatly impacted the returns of the portfolios formed during 2001/02. Between September 2008 and September 2010, all such “seven year portfolios” have had an average annual credit spread return of 243 basis points. We of course expect this average to come down during the next recession but, under any normal market unwind scenario, careful active management around market liquidity, beta exposure and name selection would greatly help mitigate the downside.
To summarise: (i) Investment grade corporate credit quality has consistently deteriorated since the financial crisis, whilst high yield credit quality has slightly improved; (ii) From a fundamentals perspective, corporate balance sheets still look to be in decent shape at this stage of the credit cycle; (iii) From a valuations perspective, investment grade credit spreads look slightly rich, whilst high yield credit spreads look slightly cheap; (iv) As credit excess returns are nearly perfectly priced through a recession, it will be key to call the end of the credit cycle and to manage the beta exposure accordingly.