The level of credit risk varies over and responds to business cycles maybe not very directly but in a systematic way. Credit risk reaches its peak during recessions when corporate defaults are common across the economy. Therefore, credit risk premia are highest during periods of economic weakness. The fall in credit spreads signals that recession may be close to the end.
During the recovery and expansion phases credit spreads decrease from their cyclical high reached over the recession. Eventually the spread becomes so narrow that they fall below their historical average. It is during these periods that default risk is perceived to be too low which results in lax lending practices. This complacency generates many bad loans during good times. Thus, the build-up of credit risk occurs during the expansion period when the perception of default risk and credit spreads are at their cyclical lows.
There is a direct relationship between profit margins and credit spreads, namely that worsening profit margins are associated with increasing credit spreads. This should not be surprising because when profit margins are high, corporations have more cash available to pay back interest on the debt and principal.
In US, credit spreads became widest during the early 1930s (Great Depression), and in the 2007-2008 crisis. During these crises the spread between the BAA-rated corporate bond and Treasury bond with the same maturity reached 500 basis points. The spread fell to the precrisis level because Fed learnt from the Great Depression experience.
The chart reveals the patterns already discussed. After World War II, over 20 years the credit spread displayed mean-reverting characteristics around the average of 100 bps. The spread widened during recessions which was followed by normalizing to the mean during the recovery and expansionary phases. Also, the spread reached its cyclical low over the mid-cycle period while the spread reverted to the mean during the following period.
The structural shift happened both in profit margins and credit spreads after 1965 – credit spreads widened and profit margins decreased. The main reasons for this were rising interest rates and increasing leverage across the economy.
This cyclicality in credit risk offers some trading opportunities to take advantage of the patterns in credits spreads. We know that the spread peaks in a recession and start falling right after the recession during the early recovery phase. Credit spreads continue narrowing through the expansion phase. One can short the spread, i.e., buy a high-yield bond and sell an investment grade bond to benefit from this compression in spreads. Since yields of junk bonds will fall more than high-quality bonds, they will gain more in value.
After the spread begin to decrease, they tend to fall below the historical average at which point it reaches the cyclical low. This is usually right before a recession. At this stage, one can buy the spread to take advantage of the widening credit spreads. This means selling junk bonds and buying investment-grade bonds at the same time through the recession because during recessions the spread becomes the widest in times of economic weakness.
Now that a recession is likely, we might see more defaults which will widen credit spreads. So, it cna make sense to go long credit risk: buy Treasury bonds and short junk, high-yield bonds.
