Economy-wide indicators

3.2 MACROECONOMIC ENVIRONMENT

3.2.1 Economy-wide indicators

3.2.1.1 Economic activity

Since 1970, the credit spread for Baa rated US corporate bonds versus treas- uries varied in an extremely broad range. The tightest spread levels were reached at the end of the 1970s, but the double-dip recession in 1980 and 1981/82 led to a massive spread widening. Corporate bond spreads peaked at 400 bps, a level that was reached again after the equity bubble burst and the US economy went through a recession in 2000/2001.

In general the corporate bond spread simply reflects the risk premium that investors demand in order to invest in corporate bonds. In this respect it is similar to the equity risk premium. The corporate bond spread has to compensate investors for different kinds of risk:

■ default risk,

■ migration risk, and

■ liquidity risk.

While liquidity risk is primarily a function of the willingness and ability of banks and brokers to provide liquidity and of investors’ readiness to take on risk, in other words, risk appetite, the other two points are related to the economic environment. The companies’ ability to generate sufficient cash flows to service their liabilities is central for the probability of default and is reflected in ratings. In general slowing economic growth, usually coupled with lower private consumption due to weak growth of labor income and rising unemployment undermines the profitability of the corporate sector.

In this context, it is worth remembering the definition of a recession. Market participants often define recessions in terms of two consecutive quarters of decline in real GDP. The National Bureau of Economic Research (NBER) which is responsible for dating recession periods, however, claims that recessions are characterized by a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production and wholesale–retail sales.

Numerous empirical studies confirm that the economic cycle is an important determinant for the performance of credit and government bond markets. They find that credit spreads are negatively correlated with GDP growth, an observation that is supported by Figure 3.2. Historically, spreads tightened during the early stages of economic expansions, and spreads widened during economic recessions. Crabbe and Fabozzi (2002) note that during the ten economic cycles since the end of the Second World War, the Baa–Aaa quality spread typically already widened in the months leading

up to a recession. After a recession began, spreads usually continued to widen, peaking approximately 10–14 months into the cycle. The magnitude of the spread widening as well as the duration of the spread widening, however, varies from cycle to cycle, depending primarily on the duration of the recession period and the magnitude of the economic downturn. The fact that credit spreads tend to widen before the business cycle peaks indi- cates that corporate bond investors often anticipate future economic devel- opments. Focusing on macroeconomic activity variables, therefore, is not sufficient to predict changes in corporate bond spreads. Investors should carefully analyze leading economic indicators as well as any evidence that corporate profitability slows or leverage increases. Both factors result in a reduced ability to generate cash flows and weakens credit quality, resulting in a higher risk of default.

Although the close relationship between credit spreads and economic activity has held most of the time since 1950, the late 1990s witnessed a significant decoupling. Companies expected long-term stable and high growth rates, driven by new technologies like internet and mobile communi- cation. Coupled with a sustained rise in profitability, an idea strongly promoted by the Fed, this expectation caused companies to invest heavily and to leverage their balance sheets. In this period maximization of shareholder value was the credo of many managers. Despite strong economic growth credit markets punished the rise of financial and operating leverage that was

Figure 3.2 Moody’s Baa corporate bond spread versus long-term treasury bonds

Source: Moody’s 0

100 200 300 400 500 600 700 800

25 28313437 40 4346 4952 55 58 61 64 67 70 7376 7982 85 88919497 00 03 Moody's Baa corporate spread over treasuries

observable across most industries and companies with widening credit spreads. Excessively high default rates in 2001 and 2002 showed that market participants anticipated the rise in systematic risk quite early. The sustained equity downturn and cases of fraud added to the woes of the credit markets.

Figure 3.3 shows the strong long-term relationship between US GDP growth and the credit quality of the US automobile industry. Because of the cyclical nature of their business, that is the dependence of corporate revenues and earnings on private consumption, and the high level of fixed costs in the automotive sector, credit ratings of the big three US car manufacturers Ford, GM and DaimlerChrysler are strongly dependent upon the state of the US economy. Hence GDP growth is a good leading indicator for the rating trend in the automotive sector. During periods of economic growth consumer confi- dence rises and car manufacturers improve their profitability by increasing car sales numbers, which leads to better credit profiles and tighter spread levels.

Markets often anticipate falling credit risk and reward improvements in the credit profile by requiring lower risk premia for the bonds of the issuers.

3.2.1.2 Interest rates

Globally, the low interest rate environment in the first years of the new millennium has spurred investors’ interest in credit as a way to boost

Figure 3.3 Dependency of US big three automotive manufacturers’

ratings from the business cycle

Source: Union Investment

1987 1989 1991 1993 1995 1997 1999 2001 2003

–3 0 3 6 AAA 9

AA+

AA AA–

A+

A A–

BBB+

BBB BBB–

BB+

BB BB–

B+

B B–

CCC

Ford Chrysler (since Nov 98 DaimlerChrysler) GDP (% yoy, rhs) General Motors

returns. However, one has to be aware that there is a correlation between the level of interest rates, the slope of the yield curve and credit spreads because both the yield curve and credit spreads reflect the state of the econ- omy. Since they are driven by expectations about the same underlying fac- tor, the relation between the yield curve and credit spreads has an impact on top-down driven asset allocation and duration decisions.

In the past, credit spreads have been closely correlated with interest rates. There is typically a negative correlation between spreads and the level of interest rates. As interest rates increase due to an improving outlook for future economic growth and rising price pressure, credit quality tends to improve because firms have opportunities to strengthen their future earnings and cashflows. Similarly, a flatter money market slope (2 years–

6 months) is usually positive for credit spreads because it indicates better economic conditions. In a difficult economic environment, such as at the trough of the recession, the money market curve tends to be very steep and credit usually underperforms treasuries, especially at the long end.

Similar to the level of interest rates itself the slope of the yield curve also is an indicator for the economic environment. Generally, the slope of the yield curve is seen as a good proxy for future economic growth and corporate prof- its. Steep yield curves imply that future rates are expected to be higher than at present. A steep 2s10s slope and a further steepening of the 2s10s slope in the past often have been followed by positive excess returns of corporate bonds. Usually, one observes a steepness in this part of the curve at the end of a recession and at the start of an expansion. When the expansion finally materializes the curve flattens, and inflation concerns cause central banks to raise interest rates. In this environment, credit usually suffers, and investors should be particularly cautious when overweighting cyclical credits.

3.2.1.3 Central bank policy

Monetary policy, too, appears to be an important indicator for corporate credit spreads. Let us assume that the economy is at the brink of deflation.

Generally, deflation tends to be accompanied by a rise in bankruptcies.

When corporate revenues and earnings are weak, highly leveraged borrow- ers have difficulties to meet their obligations. In this situation central bank easing paves the way for future economic growth. The traditional channels by which a lowering of the federal funds rate tends to stimulate faster growth in real and nominal GDP are: (1) lower debt cost of capital, (2) higher stock prices, (3) dollar weakness, (4) consumer durables, includ- ing automobiles, and (5) housing. Hence, it lowers the equity cost of capital and bolsters consumer confidence through the wealth effect. Figure 3.4 shows that Baa credit spreads usually reach their peak when the Fed has done approximately two-thirds of the interest rate cuts.

Interestingly, the relationship between equity and bond markets differs in deflation-risk periods and inflation-risk periods. In inflation-risk peri- ods, rising inflation rates push up long-term interest rates, reflecting the fear that aggressive monetary tightening will depress future earnings and hence stock prices. Thus, in periods of rising inflation risk, government bond prices and stock prices tend to fall. In deflation-risk periods govern- ment bond prices and stock prices usually go in opposite directions, because fixed income markets benefit from the expectation of falling interest rates, while equities suffer from the worsening profit outlook and increasing default risk. Credit spreads tend to benefit from rising inflation because it becomes easier for companies to pay down their debt.

Deflationary periods usually lead to a spread widening across the whole credit market, hitting consumer-related industries the hardest. However, long-term interest rates seem to have a minor influence on fluctuations of credit spreads in the short term. Companies that borrow at a fixed rate are immune to changes in yields and spreads over the life of the borrowing. Yet, there is a refinancing risk, when debt has to be rolled over. Conversely, when companies borrow at floating rates, they are directly affected by changes in money market rates, which are primarily driven by monetary policy.

Figure 3.4 Moody’s Baa corporate bond spread versus Fed Funds Target Rate

Source: Moody’s and Federal Reserve 0

2 4 6 8 10 12 14 16 18 20

71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 50 100 150 200 250 300 350 400

Fed funds target rate (lhs)

Moody's Baa corporate spread over Treasuries (rhs)

3.2.1.4 Employment

For decades economists have analyzed the behavior of various economic indicators during the business cycle. Employment is commonly seen as one of the lagging indicators for the state of the economy. However, there is a leading indicator for the labor sector that coincides with changes in credit spreads. For example, for most of the time since 1968 there has been a close relationship between credit spreads and the index of help-wanted advertis- ing. Falling demand for work force usually coincides with widening credit spreads, indicating falling profits in the corporate sector. Cost-cutting and restructuring measures are typically undertaken in this phase of the economic cycle.

So far, we have examined the impact of several of the most closely watched indicators for the overall state of the economy on corporate bond spreads. Arguably, only monetary policy and market indicators like the slope of the yield curve are true leading indicators for the performance of credit markets. When the GDP figures are published, the credit markets usually have anticipated what the outcome will be. Accordingly, employ- ment is not only a lagging indicator for economic performance, but also at best a coinciding indicator for credit spreads.

Figure 3.5 Moody’s Baa corporate bond spread and index of help wanted advertising

Source: Moody’s and Conference Board

68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 30.0

40.0 50.0 60.0 70.0 80.0 90.0

100.0 110.0 0

50 100 150 200 250 300 350 400

Moody's Baa corporate spread Help wanted index (inverted rhs)