When Riding the Credit Cycle, It Pays to Take the Short Cut

We’ve been warning investors for some time now that the current phase of the corporate credit cycle is ending. Generally, this will be bad news for corporate bonds, so why do we continue to hold them? The answer lies in knowing which bonds to hold, and which to fold.

Let’s look briefly, first, at what we mean by the credit cycle and why this phase is ending.

The credit cycle refers to the way in which the conditions under which companies borrow can change over time. For the last 10 years or so, conditions have been benign, thanks largely to the actions of central banks and governments in supporting their economies since the financial crisis.

During this time, most companies have accessed loans easily, grown their earnings and increased their overall debt.

The cycle typically peaks when the corporate debt burden reaches a point where it poses a credit risk―that is, more companies become likely to default on their loans. This risk intensifies as interest rates increase.

And that’s just what’s happening now: economic growth is becoming stronger, inflation expectations are rising and more and more central banks are “normalizing” or tightening monetary policy.

In the next phase of the cycle, investors should expect to see a decline in asset values and greater reluctance on the part of banks and bond buyers to provide debt finance. This will lead, eventually, to contraction and balance-sheet repair until the cycle begins again.

So why hold corporate bonds during this period of uncertainty?

The Sweet Spot: Seven Years or Less

One might expect longer dated-bonds and bonds with lower credit quality to underperform during the cycle’s next phase, because the risks associated with long-term loans and relatively weak balance sheets become more worrying in less favourable economic and financial conditions.

This is borne out by Display 1 below, which compares the performance of investment-grade corporate bonds in a range of maturities during market drawdowns or sell-offs.

It shows the average monthly and annual returns for global corporate bonds over the last 10 years, which include the immediate aftermath of the financial crisis. The best performers in simple terms of excess returns over government bonds are those in the five- to seven-year maturity range.

It’s worth noting, however, that the excess returns for bonds with maturities of less than five years are close to those of bonds with maturities of seven to 10 years and more. This similarity becomes more nuanced when volatility is considered.

The volatility that these short-dated bonds experience is significantly lower than that affecting other bonds. This makes the excess returns they deliver more valuable to the investor, relatively speaking, because of the lower risk involved.

In the case of both the one- to three-year and three- to five-year bonds, the Sharpe ratio―a technical expression of a security’s risk-adjusted rate of return―is higher than that for the longer-dated bonds.

On this basis, it makes sense for the manager of a fixed-income portfolio to overweight the corporate bond allocation to shorter-dated securities at this point of the credit cycle, rather than hold no corporate bonds at all.

But will this still be true if, as we expect, bond-market volatility is going to increase significantly during the next year or so as inflation, interest rates and bond yields rise?

When the Going Gets Tough…

Display 2 looks at the same monthly data as that in the top part of Display 1, but through the lens of various levels of volatility as measured by the Volatility Index or VIX.

In months when volatility has been above 15% and below 25% during the last 10 years, corporate bonds have delivered negative returns relative to government bonds. This shouldn’t be surprising, as government bonds become more appealing than corporate bonds during times of market turbulence, because of their superior credit quality.

Within the corporate bond universe, however, very short-dated bonds continue to outperform, by losing less on the downside. This holds true until volatility breaks through 25%, when excess returns across the board become positive again and very strong as mean reversion takes effect―that is, corporate bond spreads tighten as the VIX peaks and starts to move lower.

At that point, it makes sense for our hypothetical fixed-income manager to rethink the overweight to short-dated securities in favour of opportunities across the full range of corporate bond maturities.

So, the key to managing corporate bond exposures through the downswing in the credit cycle may not be to run for the exit, but to overweight the fixed-income portfolio’s corporate bond allocation to short-dated, investment-grade credits.