Credit Cycle
The credit cycle plays a pivotal role in determining the fluctuations in credit spread across various maturities and ratings. It is crucial to evaluate the probability of issuer default and the severity of loss throughout the cycle, keeping in mind the overall market perspective.
For example, consider the housing market boom in the early 2000s. Credit spread curves that were positively sloped indicated a low near-term default probability, aligning with expectations of stable or rising future inflation and strong anticipated economic growth. The demand from investors for higher credit spreads to assume the risk of downgrade or default over longer periods also contributed to a positive slope.
The level and slope of credit curves vary over the economic cycle. In the initial stages of an expansion, such as the tech boom in the late 90s, when profits were rising and defaults were still high, high-yield spreads remained high and often exceeded investment-grade spreads, which typically exhibited a flat to inverted spread curve.
Credit Cycle and Economic Growth
The credit cycle plays a pivotal role in economic growth and inflation. For instance, during an expansion phase, akin to the economic boom in the US during the late 1990s, lower defaults and increased profits lead to a decline in short-term high-yield and investment-grade spreads. This results in the steepening of credit spread curves, a phenomenon that continues as economic growth peaks, often accompanied by higher leverage and inflation expectations.
However, when economic growth decelerates or the economy enters a recession, similar to the 2008 financial crisis, credit spreads rise and spread curves flatten. In extreme cases, the high-yield curve may even invert due to falling profitability and rising defaults.
Active Credit Managers and their Role
Active credit managers, like those at BlackRock or Vanguard, incorporate the credit cycle into their economic growth and inflation forecasts. These forecasts are then translated into sector- and issuer-specific views, driving specific credit curve level and slope expectations using either the bottom-up or top-down approaches.
If the forecasts of the active credit managers align with the current credit spread curves, they will opt for active credit strategies that are consistent with static or stable credit market conditions. However, if an investor’s views diverge from what the current credit curve implies about future defaults and the severity of credit loss, they will position the portfolio to generate excess return based on this divergent view. This is done within investment mandate constraints using the cash and derivative strategies.
Static Credit Spread Curve Strategies
Static Credit Spread Curve Strategies are employed by active credit managers who believe that the current credit spreads are fairly priced and that credit curves will remain stable over an investment horizon, given low credit defaults and annual loss rates. In such a situation, a manager could enhance portfolio returns by either lowering the portfolio’s average credit rating or increasing credit spread duration by investing in longer-dated bonds with a similar rating to the current portfolio.
By tilting the portfolio towards lower-rated bonds, such as moving from an average A rated to BBB rated portfolio, the expected spread return increases.
$$E [\text{ExcessSpread}] \approx \text{Spread}_0 – (\text{EffSpreadDur} \times \Delta \text{Spread}) – (\text{POD} \times \text{LGD})
$$
Increasing Credit Spread Duration
The second strategy involves increasing the credit spread duration through a “buy and hold” or “carry and roll down” approach, a concept familiar from yield curve strategies.
This delves into specific investment strategies that involve risky bonds and derivative-based credit strategies. These strategies are crucial for investors seeking to maximize returns and manage risk.
Risky Bonds Strategy
One strategy involves purchasing risky bonds with durations exceeding the benchmark. This strategy does not require active trading during the subsequent period. The success of this strategy hinges on the stability of the relationship between long- and short-term credit spreads over the investment horizon. If this relationship remains stable, the manager is rewarded with a higher return due to the increased spread duration. For instance, if an investor purchases a high-yield corporate bond with a longer duration than the benchmark US Treasury bond, they could potentially earn higher returns if the credit spreads remain stable.
“Rolling Down” the Credit Curve Strategy
Another strategy is “rolling down” the credit curve. This strategy generates incremental coupon income, adjusted over time for any price difference from par due to wider spreads. Additionally, this strategy also adds return from the passage of time and the investor’s ability to sell the shorter-maturity position in the future at a lower credit spread at the end of the investment horizon.
Derivative-Based Credit Strategies
The notes also explore derivative-based credit strategies that aim to add credit spread duration or increase credit exposure. These strategies may involve selling CDS single-name or index protection for longer maturities or lower credit quality. Alternatively, a long-short approach may be used to achieve a similar objective.
Dynamic Credit Spread Curve Strategies
In the field of active credit managers employ strategies to leverage differing market perspectives. These strategies, either cash-based or derivative, are tailored to specific issuers, sectors, or the overall credit market over the credit cycle. They aim to exploit expected changes in the credit curve across maturities and rating categories.
Positioning a Credit Portfolio
Active managers may position a credit portfolio to generate excess return in anticipation of these changes. For instance, they might source and borrow Ba- and B rated bonds to sell short at no cost. However, it’s crucial to understand that the availability and cost of shorting bonds can vary over the economic cycle. For example, during an economic slowdown, shorting bonds can become more challenging and costly.
Synthetic, CDS-based Strategy
A synthetic, CDS-based strategy aims to reduce the likelihood of near-term financial distress, leading to lower credit spread levels and a steeper credit curve. This effect is more pronounced for lower-rated issuers in cyclical industries, such as the automotive or construction sectors.
Active managers can leverage changes in the credit curve and the credit cycle to generate excess returns in both cash and synthetic markets.
Practice Questions
Question 1: Consider a scenario where the economy is in the early stages of an expansion. Profits are increasing, but defaults are still high. In this context, the credit spread curves for high-yield bonds and investment-grade bonds are observed. The high-yield spreads remain high and are often above the investment-grade spreads, which typically display a flat to inverted spread curve. What does this scenario indicate about the credit cycle and the investors’ perception of risk and return?
- The credit cycle is in a contraction phase, and investors are demanding higher credit spreads due to the increased risk of downgrade or default over longer periods.
- The credit cycle is in an expansion phase, and investors are demanding lower credit spreads due to the decreased risk of downgrade or default over longer periods.
- The credit cycle is in an expansion phase, and investors are demanding higher credit spreads due to the increased risk of downgrade or default over longer periods.
Answer: Choice C is correct.
The scenario described indicates that the credit cycle is in an expansion phase, and investors are demanding higher credit spreads due to the increased risk of downgrade or default over longer periods. In the early stages of an economic expansion, profits are increasing, but defaults are still high. This is because the effects of the previous contraction phase are still being felt, and many companies are still struggling with high levels of debt and weak cash flows. As a result, the risk of downgrade or default is still high, especially for high-yield bonds, which are issued by companies with lower credit ratings. This is reflected in the high-yield spreads, which remain high and are often above the investment-grade spreads. The flat to inverted spread curve for investment-grade bonds indicates that investors do not expect the risk of downgrade or default to increase significantly over longer periods. This is typical in an expansion phase, when economic conditions are improving and the risk of downgrade or default is expected to decrease over time.
Choice A is incorrect. The scenario does not indicate that the credit cycle is in a contraction phase. In a contraction phase, profits are typically decreasing, not increasing, and the risk of downgrade or default is increasing, not decreasing. Also, in a contraction phase, the spread curve for investment-grade bonds is typically upward sloping, not flat or inverted, as investors demand higher credit spreads for longer periods due to the increased risk of downgrade or default.
Choice B is incorrect. While the credit cycle is indeed in an expansion phase, the scenario does not indicate that investors are demanding lower credit spreads. On the contrary, the high-yield spreads remain high, indicating that investors are demanding higher credit spreads due to the increased risk of downgrade or default over longer periods.
Question 2: Active credit managers play a significant role in incorporating the credit cycle into their economic growth and inflation forecasts. These forecasts are then translated into sector- and issuer-specific views, which drive specific credit curve level and slope expectations using either the bottom-up or top-down approaches. If the forecasts of the active credit managers coincide with the current credit spread curves, they will choose active credit strategies that are consistent with static or stable credit market conditions. What strategy will active credit managers likely adopt if their forecasts do not align with the current credit spread curves?
- They will position the portfolio to generate excess return based on this divergent view.
- They will continue to choose active credit strategies that are consistent with static or stable credit market conditions.
- They will abandon their forecasts and adopt a passive credit management approach.
Answer: Choice A is correct.
If the forecasts of the active credit managers do not align with the current credit spread curves, they will likely position the portfolio to generate excess return based on this divergent view. This is because active credit managers, unlike passive managers, have the flexibility to adjust their portfolios based on their views and expectations about the future. If they believe that the current credit spread curves do not accurately reflect the future, they can take positions that are contrary to the market consensus. This could involve buying or selling specific securities, adjusting the duration of the portfolio, or changing the sector or issuer concentration. By doing so, they aim to generate returns that exceed the benchmark or the market average. This strategy is consistent with the active management approach, which involves making investment decisions based on research, analysis, and professional judgment, rather than simply following a benchmark or index.
Choice B is incorrect. If the forecasts of the active credit managers do not align with the current credit spread curves, they will not continue to choose active credit strategies that are consistent with static or stable credit market conditions. This is because such strategies would not be appropriate given their divergent view. Instead, they would adjust their strategies to reflect their expectations about the future.
Choice C is incorrect. Active credit managers will not abandon their forecasts and adopt a passive credit management approach if their forecasts do not align with the current credit spread curves. This is because the essence of active management is to make investment decisions based on forecasts and expectations about the future, even if these do not align with the current market conditions. Abandoning their forecasts and adopting a passive approach would be contrary to the principles of active management.
Glossary
- Credit Cycle: The progression through which credit is accessed, utilized, and repaid by borrowers, influencing economic activity and financial stability.
- Credit Spread: The difference in yield between a corporate bond and a government bond of the same maturity, reflecting the credit risk associated with the corporate bond.
- E [ExcessSpread]: The expected additional yield that an investor anticipates receiving from a bond over its risk-free rate.
- Effective Spread Duration (EffSpreadDur): A measure of a bond’s price sensitivity to a change in credit spreads.
- Change in Spread (ΔSpread): The variation in the credit spread of a bond over a specified period.
- Probability of Default (POD): The likelihood that a borrower will be unable to meet their debt obligations.
- Loss Given Default (LGD): The amount of loss a lender incurs when a borrower defaults, expressed as a percentage of total exposure at the time of default.
- Derivative-Based Credit Strategies: Investment approaches utilizing credit derivatives to manage risk and enhance portfolio returns.
Portfolio Management Pathway Volume 2: Learning Module 6: Fixed-Income Active Management: Credit Strategies.
LOS 6(g): Discuss various portfolio positioning strategies that managers can use to implement a specific credit spread view