Credit where it's due
Recent outflows from high-yield bond funds prompt worries that the ‘credit cycle’ may finally be turning. This article details the concept of a ‘credit cycle’ and considers it in relation to our current financial environment.
Nuveen Asset Management, in a recent market report, identified the credit cycle as the expansion and contraction of credit over time. The performance of investment grade and high-yield corporate bonds, as well as equities, is considered a key gauge of the financial system’s position in the cycle. Nuveen highlight four key phases of the cycle: (1) Downturn: Here we see default rates spike and corporate assets tank, often reflected in large spreads on corporate over government debt – this phase is often associated with recession (2) Repair: As the economy emerges from recession and companies repair their balance sheets, spreads decline (indicating increasing confidence in the corporate sector) (3) The economy continues to strengthen and companies continue deleveraging, thus driving continued gains in corporate assets and finally (4) Robust economic growth and high levels of confidence drive increasing leverage, corporate assets experience volatility as the credit cycle peaks.
Figure 2 demonstrates the relationship between periods of recession and corporate debt yields – as the default rate spikes investors demand increasingly high premiums to compensate themselves for risk, thus causing yields to sky-rocket. As we can see, the relationship between the economic cycle and the credit cycle is incredibly strong. Therefore, though it is often difficult to tell where the causality lies – i.e. whether contracting credit induces an economic downturn or whether an economic downturn reduces the availability of credit – this question of what part of the cycle we are in ought to be of great interest to financiers and economic policymakers alike.
Where are we?
Several signs point to a mature global economy reaching the peak of the credit cycle. This raises concerns that the economy, and indeed asset markets, may be on the brink of a sharp downturn. Credit conditions are at their loosest in perhaps all of modern economic history. This is best captured by the growth of so-called ‘Cov-lite’ lending. Traditionally, when a high-credit risk company issues debt, it comes with a number of restrictions or ‘covenants’ on the borrower – such as a limit on how much further debt they can take on. Due to the risky nature of the investment, this is designed to protect the lender’s investment. Cov-lite loans lack these provisions and thus allow borrowing on very accommodative terms. As shown by Figure 3, Cov-lite lending in the speculative-grade (i.e. high yield) market has increased from 27% to two-thirds of the total in Europe, the Middle-East and Africa. In a further display of investor appetite for risk, we saw Swedish bank Nordea issue ‘CoCo bonds’ for the lowest yield in European history. These bonds are especially risky as the company retains the right to convert them into equity in times of financial distress and hence not pay the original sum owed.
Things may indeed be turning for the worst. US junk bond funds, which hold risky corporate debt, have seen four weeks of the largest outflows ever – with $4.4 billion in net withdrawals in the week to November 15th alone. There are fears of contagion from the bond markets spilling over into equities: as yields on bonds rise, equities will become less and less attractive as an investment. Furthermore, the flattening yield curve (i.e. a compression of the difference between short and long-term yields on Treasuries) in the United States indicates heightened possibility of recession. Faced with this, it may seem tempting to conclude that the credit cycle is indeed about to turn.
Reasons for reticence
Despite the market gloom, there are several reasons to doubt an imminent credit collapse. As Nuveen Asset Management highlights, credit cycles do not simply die of old age – some external shock has to destabilise them. There are solid fundamentals supporting financial stability: corporate earnings are high and default rates low and falling. Furthermore, banks, key drivers of credit expansion, are well-capitalised and thus well-placed to continue lending. This is all alongside incredibly accommodative monetary policy from the major central banks: despite gradual tightening by the Federal Reserve and Bank of England, as well as the ECB’s potential ending of QE, interest rates remain at historic lows and central-bank-provided liquidity at historic highs. Those forecasting imminent doom have been wrong for the past decade and are likely to continue being so. None of this is to claim that the credit cycle won’t turn – it undoubtedly at some point in the future – and given how highly valued corporate assets have been as of late, they will have a long way to fall.