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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1. See for example Estrella and Mishkin (1996) and Estrella and Trubin (2006). Moreover, Rudebusch and Williams (2009) document the enduring feature of this phenomenon over time, and provide evidence that simple yield curve-based forecasts of recessions outperform subjective forecasts from the Survey of Professional Forecasters.
2. The credit impulse refers to the change in credit growth, and it is found to be highly correlated with GDP growth (see Biggs et al (2009)).
Balla, Eliana, and Carpenter, Robert E., and Mark D. Vaughan. 2007. “Decoding Messages from the Yield Curve.” Region Focus, Federal Reserve Bank of Richmond, vol. 11, no. 2 (Spring): 37-39.
Biggs, Michael, and Mayer, Thomas, and Andreas Pick. 2009. “Credit and Economic Recovery.” De Nederlandsche Bank Working Paper, no. 218 (July).
Estrella, Arturo, and Frederic S. Mishkin. 1996. “The Yield Curve as a Predictor of U.S. Recessions.” Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 2, no. 7 (June).
Estrella, Arturo, and Mary R. Trubin. 2006. “The Yield Curve as a Leading Indicator: Some Practical Issues.” Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 12, no. 5 (July).
Lown, Cara and Donald Morgan. 2006. “The Credit Cycle and the Business Cycle: New Findings Using the Loan Officer Opinion Survey.” Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38, no. 6 (September):1575-1597.
Rudebusch, Glenn D., and John C. Williams. 2009. “Forecasting Recessions: The Puzzle of the Enduring Power of the Yield Curve.” Journal of Business and Economic Statistics, American Statistical Association, vol. 27, no. 4:492-503.
BAA―UST 30Y: Quarterly Moody’s Corp. BAA yield-to-maturity minus U.S. 30-year Treasury yield-to-maturity. The Moody’s Corp BAA Index is derived from a universe of bonds with maturities as close as possible to 30 years, excluding any bond with a remaining maturity of less than 20 years. There is no 30-year Treasury data prior to 2/15/77; therefore, we backfill the history back to 1966 using the 10-year Treasury rate.
C&I Lending Standards: We use the question on standards for commercial and industrial (C&I) loans to large- and middle-size firms. The C&I question in its current form dates back to the 1960s, excluding a brief halt between 1984Q1 and 1990Q1. This data is available from the Federal Reserve only from the re-inception point of the survey in 1990Q2. However, Donald Morgan of the Federal Reserve Bank of New York maintains the original series at http://newyorkfed.org/research/economists/morgan/pub.html. To fill the gap, we use a similar survey pertaining to loan officers’ willingness to make consumer installment loans, which dates back to the 1960s without interruptions (see Owens and Schreft (1991) for further detail). We regress the original C&I series on contemporaneous values of the consumer installment series and lagged values of our debt variable and use estimated coefficients to backfill the C&I series from 1984Q1 to 1990Q1.
The Federal Reserve’s Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) measures the net percentage of loan officers reporting a tightening in lending standards over the quarter.
The Barclays IG Corp. ER Index is defined as the return of the Barclays U.S. Aggregate Bond Index minus a duration-matched U.S. Treasury TR series.
The JPMorgan HY Corp. Total Return (TR) Index is a dollar-denominated index consisting of non-investment-grade corporate bonds, which are issued by both U.S. and non-U.S. companies.
The Credit Suisse HY Corp. Index tracks the performance of domestic non-investment-grade corporate bonds.
Indices are unmanaged and cannot be purchased directly by investors.
Fixed income investing entails credit and interest rate risks. When interest rates rise, bond prices generally fall.
Mutual funds and exchange traded funds are subject to market risk and volatility. Shares may gain or lose value.
These views represent the opinions of the Portfolio Manager at OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.