Wednesday, September 19, 2018

Market Timing The Credit Cycle

Over the last few years, you’ve likely heard the following competing narratives: ­

  • “Credit spreads are tight, a sign of exuberance among investors that are willing to overlook risk. This will end in tears.” 
  • “Credit spreads are tight, reflecting an environment of high economic growth and low default rates. This supports risk assets.” 
This post will outline why both of the above comments may be correct (or incorrect) by looking at asset class performance over various time frames / over recent credit cycles.


Corporate bond spreads can be thought of as an indicator of the overall creditworthiness of the private sector, with widening spreads either reflecting a difficult environment for companies to service their debt or the perception by investors that it may be difficult for these companies to service their debt. In this post, credit risk is defined as the difference in the option adjusted spread “OAS” (the difference in yield between a corporate bond and similar duration Treasury bond) between junk bonds and investment-grade corporate bonds, which I’ll refer to as “quality spread”.

The chart below outlines the month-end "quality spread" in percent terms going back to 1994, a time frame that goes as far back as I can get the high yield OAS data, as well as two bands reflecting one standard deviation above and below the three year month-end average spread.

Quality Spread Since 1994 (as far back as Barclays reports High Yield OAS) - %

As the chart above highlights, credit spreads can be highly cyclical, which I’ll bucket as: ­
  • Tight: More than one standard deviation below average ­
  • Normal: Within a one standard deviation band ­
  • Wide: More than one standard deviation above average 
Are tight or wide spreads a better indicator for forward risk taking? Let’s take a look.

Credit Spreads vs Longer-term Returns 

Bucketing each starting month-end period into tight, normal, or wide buckets, the forward five-year average performance of investment grade corporate bonds, high yield corporate bonds, and the S&P 500 for the 1997-2018 time frame is shown below (1997 is the first data point for the bands three years forward from the 1994 starting date).

The result is that while riskier asset classes returned more on average over the whole period: ­
  • Forward five year returns of all three asset classes were noticeably lower when the starting yield of the “quality spread” was low ­
  • In fact, both high yield bond and the S&P 500 average returns were less over the subsequent five years than the returns on the Treasury index when the starting spread was more than one standard deviation below average
  • When the “quality spread” was elevated, average excess performance was exceptionally high in both absolute and relative terms five years forward

In summary… over these longer-term windows, a low spread = a lower return (which would seem to indicate longer-term investors may currently be taking excess / uncompensated risk).

Credit Spreads vs Shorter-term Returns

Using the same 1997-2018 time frame and spread buckets, we can see that over the short-term (one-month forward time frame) the opposite narrative appears to be true: ­
  • Risk assets performed better when spreads were tight than when spreads were wide ­
  • In fact, the best short-term period for stocks were when spreads were more than one standard deviation below their average ­
  • Both high yield and stocks performed worse than Treasuries when spreads were wide 

In summary… over the shorter-term, low spread seems to = a higher return (which would seem to indicate investors may be more than fairly compensated to take risk given current fundamentals).


The below charts break out investment grade bonds, high yield bonds, and S&P 500 further, charting the return (geometric one month forward annualized) ­and risk (standard deviation) by:
  • Spread levels (narrow, normal, or wide) ­
  • Spread direction (i.e. whether the "quality spread" has narrowed or tightened) 

Investment Grade Corporates

Geometric Annualized Forward One-Month Return vs Month-End Starting Yield / Direction of Spreads 

Investment grade corporates provided positive performance in all of the various environments in this time frame, but volatility did pick up when spreads were both elevated and widening (as a frame of reference, IG Corporate bonds did outperform Treasuries in all of these environments except when spreads were elevated and widening - a period where they underperformed by 6%).

High Yield Corporates

Geometric Annualized Forward One-Month Return vs Month-End Starting Yield / Direction of Spreads

The results for high yield seem more interesting. High yield returns were relatively steady in both low spread and “normal” spread environments, but the volatility of high yield was materially lower when spreads were narrow. Things were especially interesting at higher spread environments as there was: ­
  • Underperformance: when spreads were wide and widening (“catching a falling knife”) ­ 
  • Outperformance: when spreads were wide and narrowing (an investor was able to successfully capture these higher than normal yields in this window) 

US Stocks

Geometric Annualized Forward One-Month Return vs Month-End Starting Yield / Direction of Spreads 

S&P 500 returns were especially strong when spreads were narrow, as well as when spreads were “normal” and moving wider (perhaps noise over the previous month presented a buying opportunity). What I found interesting was the linear relationship between the level of spread and volatility (narrow spreads = much lower volatility). Finally, I found it interesting that the performance of US stocks was poor when spreads were elevated (irrespective of whether spreads were narrowing or widening, unlike the divergence in performance within high yield).


The good news is the above analysis may provide some interesting signals for those with the flexibility to allocate tactically.

The bad news is that while I think the relationship between spread and the shorter-term performance outlined above makes logical sense, it may not work going forward.

So the next time someone asks for a quick answer as to whether tight spreads have been a sign of exuberance among investors who were willing to overlook risk (which will end in tears) or an environment of high economic growth and low default rates, supporting risk assets... you can now respond.

It depends.

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