Sir John Templeton once said, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria,” which is still relevant and directly applicable to equity markets. Unsurprisingly, the credit cycle that affects economic conditions and investor confidence also follows this ideology.
In the fixed-income market, the expansion and contraction of access to credit directly influences the economic growth of corporations or municipalities. Investors might draw some relevance between the business and credit cycle as there is a direct correlation; however, the credit cycle plays an integral role in the corporate world. Where the business cycle measures the overall economic expansion or contraction that could greatly affect the well-being of any business, the credit cycle could limit a business entity’s access to credit, thereby increasing the credit-spreads and potentially limiting a firm’s ability to grow.
In this article, we’ll take a closer look at the four different phases of a credit cycle, its impact on the business cycle and explore some ways for bond investors to capitalize on the various stages of the credit cycle.
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What Is the Credit Cycle?
The growth or expansion of any business or municipality is heavily based on its access to capital markets. Indirectly, this contributes to the region’s overall economic growth. The credit cycle monitors both the expansionary and contractionary phases. In the expansionary scenario, credit standards are loosened and enterprises have easier access to capital for growth. As they grow, they tend to take up financial leverage. Meanwhile, in the contractionary scenario, credit standards are tightened, leading to a decline in enterprise growth.
Let’s take a look at the four phases of a typical credit cycle.
Expansion: Under strong economic conditions, corporate cash flows improve due to strong consumer confidence and the increase in financial institutions’ lending efforts. Easier access to capital markets fosters an ideal environment for business growth and increase in financial leverage for enterprises. During the expansionary phase, credit spreads are also tight, which means that the yield difference between a corporate security and treasuries, with the same maturities, is narrow. This indicates higher investor confidence in corporate debt. As a result, investors are willing to accept smaller compensation for the credit risk.
Downturn: The credit cycle downturn is typically due to an economic slowdown or potential recession, which leads to tighter credit standards for financial institutions and weak access to capital markets. Since the credit downturn is often preceded by peak business expansion and high financial leverage, the slow business growth and low earnings experienced by businesses in this phase are detrimental and could lead to potential defaults. This phase tarnishes investor confidence in corporate debt and they tend to shift toward safety over higher yields. Hence, the credit spread between treasuries and corporate debt widens.
Repair: The credit cycle downturn is followed by the repair phase, which simply indicates the emergence from the economic downturn. Here, companies start to focus on strengthening their balance sheets by cutting costs and reducing financial leverage. Investors are still skeptical about corporate debt and prefer safety, thus narrowing the credit spreads.
Recovery: In the recovery phase, confidence levels start to improve as corporate balance sheets begin to look better with relatively low financial leverage. Financial institutions also tend to start loosening their lending standards. During this phase, the credit spreads continue to narrow.
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Understanding Credit Cycle in the Current Context
This is an important concern for many fixed-income investors. Following the 2008 financial crisis, the economy has been in a thriving mode and businesses have seen much growth. If the credit cycle is repetitive, when can we expect the next downturn in the business and credit cycle?
This question can be answered by following historical credit cycles and patterns in the widening of credit spreads. In the graph below, we can examine the history of three credit cycles and the widening of credit spreads.
As the graph shows, we have already seen the credit spread widening in early 2017, which is indicative of decline in investor confidence and their preference for safety over yields. This does not necessarily mean that the economy is entering a downturn, but rather indicates the maturity of the expansion phase.
However, there are certain factors that differentiate the current credit cycle from all the previous ones, and there are some clear indications as to how economic growth is more sustainable than before. One of the indicators is the Federal Reserve’s active role in normalizing interest rates. The Fed has taken an active role in keeping interest rates low irrespective of economic growth. This has also kept capital markets very desirable for enterprises to raise capital. Furthermore, sustainable GDP growth, the banking systems’ strong financial health and strong corporate balance sheets will play an important role in softening the blow of the new credit cycle phase.
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The Bottom Line
Sir John Templeton’s quote is still very relevant to investor confidence, which is directly related to the economy’s business and credit cycles. The skepticism of fixed-income investors, as the credit cycle approaches the end of its expansion phase, is very valid; however, this might not be the end of the expansion phase. Investors should consider limiting their overall exposure to high yield debt and start considering safety over yield. This does not mean completely foregoing the potential yield from the corporate sector, as some investment-grade corporate debt could potentially provide the consistent income that fixed-income investors look for.
In the end, every investor should consult with their financial advisor or fixed-income professionals before executing any trades or employing any portfolio strategies.
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