Investing in credit markets can potentially offer very attractive returns over time. However, credit also experiences transitory periods of high volatility and significant drawdowns, which can severely impact investors’ portfolios.
To understand what drives the performance of credit markets, we identify three stages in the credit cycle (summarized in the chart below) with the following historical patterns:
- Beginning of the Cycle: Credit outperforms government bonds via significant spread compression.
- Mid-Cycle: Despite low spreads, credit offers long periods of stable returns from income, still outperforming government bonds.
- End of the Cycle: Credit experiences heightened volatility and large drawdowns, underperforming government bonds.
We have developed a macro framework to anticipate turning points in credit markets, estimating the probability of experiencing regimes of large and persistent credit underperformance (i.e., the end of the credit cycle).
We believe this framework can help investors harvest the credit risk premium while significantly reducing downside risk, therefore improving risk-adjusted performance.
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