Credit Cycle Regimes: A Theoretical Framework
In hindsight, historical cycles in credit spreads have followed a sequence of three stages, (illustrated in the chart below) characterized by the following macro dynamics and market return characteristics:
- Beginning of the Cycle: At the end of recessions, credit spreads tend to tighten sharply over a short period of time, usually just a few quarters, in response to stabilization in economic activity, aggressive monetary policy easing and loosening lending standards. Examples of these episodes occurred in 1991, 2003 and in 2009. In terms of asset returns, this phase sees credit outperform government bonds due to both strong price appreciation and higher income.
- Mid-Cycle: As the economy continues to improve, ample credit creation supports investment spending and employment growth. As the corporate sector begins to relever, monetary policy gradually begins to tighten in response to stronger labor markets and rising inflation. In this environment, spreads stabilize around or below their historical long-term average, exhibiting low volatility for several years. While credit markets may still experience occasional turbulence, by and large these spread-widening episodes are short lived, not associated with rising default rates, and quickly reversed. This kind of regime occurred between 1992 and 1997, between 2004 and mid-2007, and between 2010 and 2014. From an investment standpoint, valuations may seem expensive due to tight spreads. However, this phase actually represents an attractive “carry environment” in which the case for credit is mostly centered on earning income, rather than expectations of price appreciation.
- End of the Cycle: Finally, credit markets enter what we call “the end of the credit cycle.” After years of debt accumulation in the system, high leverage increases the vulnerability of the corporate sector to external shocks such as slowing economic growth, tightening lending standards, and so on. These shocks can cause credit spreads to widen aggressively with persistent momentum, leading to rating downgrades, rising default rates and credit contraction. Examples of this regime occurred between 1998 and 2002, and from mid-2007 through 2008. In this third phase, higher-quality credit outperforms and credit markets substantially underperform government bonds.
After modeling the macro dynamics within the credit cycle, we develop an empirical framework to measure and predict the three stages of the cycle in real time. Finally, we assess whether the performance of credit markets maps intuitively across these different regimes.
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