The DWS Macro Metric Part II – Investment Grade

The credit cycle is a natural outcome of the business cycle, with corporate profits as its transmission channel. Investors can try to map the evolution of the credit cycle to inform tactical asset allocation in fixed income markets.
We reinvoke the “DWS Macro Metric” - the ratio of Leading-to-Coincident Economic indicators - to see if we can glean any insights about the performance of investment grade (IG) corporate credit when the business cycle is inflecting from a trough.
We find that, during the five upward inflections over the last fifty or so years, the subsequent 18-month performance of IG fixed income has been stronger than treasury securities of a similar duration, and by more than all the average 18-month returns.
Finally, we show that the average outperformance is relatively stable to the timing around the inflection point, but that, helpfully to the investor, its volatility goes down as the inflection point is passed (allowing more certainty over its identification).

Bonds and the Business Cycle

Finance and psychology go hand in hand. When you work in the former field, you simply cannot avoid a default grounding in the latter. And the impact of the human tendency to lurch between euphoria and despair (and back again) is never more evident than in the cyclical pattern that one can observe in certain economic phenomena.

In our view, Figure One shows just such a pattern. It is the closely watched series known as the Senior Loan Officer Opinion Survey (SLO). Every quarter the Fed sounds out the providers of credit at large US banks to determine changes in their lending conditions. A net tightening of such conditions maps to a higher reading on the chart, so the way to interpret this is that spikes represent weak demand for credit, while lower readings represent business as usual.

“Superior investing doesn't come from buying high-quality assets, but from buying when the deal is good, the price is low, the potential return is substantial, and the risk is limited.”

- Mastering the Market Cycle, by Howard Marks

It is surely reasonable to conclude that there is a degree of cyclicality in the data, which, for us, makes perfect sense. After all, if the business cycle tracks the oscillations of economic growth, and corporate profits are one component of that growth, then we would expect to see the willingness of credit officers to lend to those companies change over time.

The literature on credit cycles is vast, but we like the relatively simple explanation that the renowned investor Howard Marks provides in his book, Mastering the Market Cycle. In this text, he provides a straightforward description of the credit boom and bust cycles. It runs along these lines:

The Boom

Strong economic growth, and a period of prosperity leads to…
…an increase in capital provision, and an increase of the capital base.
Bad news becomes scarce, which leads lenders to underestimate risk, and risk aversion to plummet.
Now, financial institutions try to expand their businesses, i.e., to provide even more capital.
This competition for market share lowers required returns and credit standards, and eases covenants.

The Bust

As first losses from these covenant light loans appear, lenders become nervous.
Risk aversion rises, as do interest rates, credit restrictions, and covenant requirements.
Now less capital is made available, and, eventually, is offered only to the most qualified of borrowers.
Companies become starved of capital; some are unable to roll their debts…
…leading to debt defaults and bankruptcies, and ultimately contributing to an economic contraction.