Credit markets work in cycles. Cycle lengths are not neatly defined by a calendar, but their peaks and valleys are apparent.
The credit cycle’s extreme periods occur when (a) lender confidence is really high and borrowing companies can access debt markets at low rates; and (b) when lender confidence is really low and borrowing companies are charged higher rates.
So where do we currently reside in the credit cycle? To answer this question, let’s start by looking at return potential.
In our analysis, investors in investment-grade fixed income may only expect modest returns on the basis of the carry (the yield being earned), which is the risk-free rate plus a credit spread; and the potential impact of the change in spread on a bond’s price. Consider the historical credit spreads (as reflected in option-adjusted spreads, or OAS1) of the Bloomberg Barclays U.S. Aggregate Index, a broad investment grade index covering the U.S. fixed income market, as shown in Exhibit 1. One can observe the market’s peaks and troughs, as well as several mini-cycles connecting these points, from which we discern that today’s potential return is at a low starting point given historically tight spreads.
The above is an aggregate of multiple different bonds markets, but even when looking at markets more granularly, we conclude the same. As Exhibit 2 shows, more focused indexes segregated by asset class, maturity, ratings and geography all show credit spreads trading at their tightest levels over the past 10 years.
It is important to note that despite recent and rather violent market volatility, we do not believe we are at the imminent end of the cycle. Credit cycles typically end with the U.S. economy slowing, aggressive Federal Reserve (Fed) tightening of monetary policy, and/or exceedingly high credit growth. In fact, the U.S. economy has posted several years of consecutive growth in gross domestic product (GDP), leading indicators and consumer and business confidence remain high, and the recently enacted tax reforms should provide an incremental short-term tailwind. The Fed has embarked on a tightening path, though its course is intended to be modest, since U.S. inflation data, such as the core PCE (personal consumption expenditure) price index,2 does not currently appear to be exceeding the Fed’s 2% inflation target. And as Exhibit 3 shows, credit has been expanding, but still at more modest levels when compared with prior turning points in the cycle. While none of these conditions appear alarming at present, we do not believe they will last—and conclude that the credit market has indeed reached a mature stage in the cycle.
What Does This Mean for Investors in Investment-Grade Debt?
From an overall portfolio-construction perspective, we firmly believe that investment grade bonds ultimately need to serve as ballast so that they could potentially hold value during periods of volatility. Given our view of modest return potential—and our realization that the highly favorable credit conditions will not last—we believe that now is not the time to overreach for incremental yield in riskier components of the credit markets. Aside from generally avoiding higher beta3 sectors like emerging-markets, “deep” high yield (i.e., bonds rated B or below) and collateralized loan obligations (CLOs), we have actually de-risked our portfolios to reflect growing downside risks as this credit cycle progressed. We look to maintain our more modest overweight and are unlikely to add to our risk exposure absent materially wider spreads.
The Bloomberg Barclays US Aggregate Index is broad-based index often used to represent investment grade bonds being traded in United States.
The Bloomberg Barclays US Aggregate Credit Index provides a measure of the performance of the U.S. dollar denominated investment grade bond market, which includes investment grade government bonds, investment grade corporate bonds, mortgage pass through securities, commercial mortgage backed securities and asset backed securities that are publicly for sale in the United States.
The Bloomberg Barclays US Aggregate CMBS Index measures the U.S. dollar-denominated, fixed-rate taxable bond market consisting of agency and non-agency commercial mortgage-backed securities.
The Bloomberg Barclays US Aggregate ABS Index measures the U.S. dollar-denominated, fixed-rate taxable bond market consisting of agency and non-agency commercial asset-backed securities (ABS).
The Bloomberg Barclays US Corporate High Yield Index measures the U.S. dollar-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch and Standard and Poor’s is Ba1/BB+/BB+ or below.
The Bloomberg Barclays U.S. Corporate 1-5 Year Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes U.S. dollar-denominated securities with maturities of 1-5 years that are publicly issued by U.S. and non-U.S. industrial, utility and financial issuers.
The Bloomberg Barclays Long U.S. Corporate Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes U.S. dollar-denominated securities with long maturities (12-30 years) that are publicly issued by U.S. and non-U.S. industrial, utility and financial issuers.
The Bloomberg Barclays U.S. Corporate Aaa-A Rated Index measures the performance of Aaa to A, or equivalently rated, fixed-rate U.S. dollar-denominated bonds issued by U.S. and non-U.S. corporations.
The Bloomberg Barclays US Corporate BBB ex-Financial Index measures the performance of BBB, or equivalently rated, fixed-rate U.S. dollar-denominated bonds issued by U.S. and non-U.S. corporations, excluding financial corporations.
The Bloomberg Barclays Ba US High Yield Index measures the U.S. dollar-denominated, high yield, fixed-rate corporate bond market consisting of securities of Ba-type or equivalent rating.
The Bloomberg Barclays B US High Yield Index measures the U.S. dollar-denominated, high yield, fixed-rate corporate bond market consisting of securities of B-type or equivalent rating.
The Bloomberg Barclays Euro Aggregate Corporate Index (IG) is a benchmark measuring investment grade, euro-denominated, fixed-rate corporate bonds with a maturity of 1 year and above.
The Bloomberg Barclays Euro High Yield 3% Index is a benchmark measuring high-yield, euro-denominated, fixed-rate corporate bonds.
The Bloomberg Barclays U.S. MBS Fixed Rate Index measures the U.S. dollar-denominated, fixed-rate taxable bond market consisting of agency and non-agency mortgage-backed securities.
The indices shown are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any Oppenheimer fund. Past performance does not guarantee future results.
- ^OAS is the yield spread which has to be added to a benchmark yield curve to discount a security's payments to match its market price, using a dynamic pricing model that accounts for embedded options.
- ^The "core" PCE price index is defined as personal consumption expenditures (PCE) prices excluding food and energy prices. The core PCE price index measures the prices paid by consumers for goods and services without the volatility caused by movements in food and energy prices to reveal underlying inflation trends.
- ^Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), which calculates the expected return of an asset based on its beta and expected market returns.
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Mutual funds and exchange traded funds are subject to market risk and volatility. Shares may gain or lose value.
Fixed income investing entails credit and interest rate risks. Interest rate risk is the risk that rising interest rates or an expectation of rising interest rates in the near future, will cause the values of a fund's investments to decline. Risks associated with rising interest rates are heightened given that rates in the U.S. are at or near historic lows. When interest rates rise, bond prices generally fall, and a fund’s share prices can fall. Below-investment-grade (“high yield” or "junk") bonds are more at risk of default and are subject to liquidity risk.
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