4.4 CREDIT CURVE POSITIONING
4.4.1 Macroeconomic drivers of the slope of the credit curve
representative for past economic cycles in the sense that it displays the usual pattern for the correlation between yield curve steepness and indus- trial production. But it is special because it comprises the longest economic expansion in the United States since the NBER started dating recessions back in the 1850s.
The management of the yield curve is a central element of fixed income portfolio management, even for corporate bond investors. However, many of them tend to take no or rather small active exposures with respect to duration and the positioning on the yield curve. Consequently, active positions with regard to sector and issuer exposures are responsible for a large part of the out- or underperformance versus the benchmark index.
Since corporate bonds as an asset class clearly depend on the boom and bust of the economy, it seems natural that not only the spread level but also the slope of the credit curve may – similar to the slope of the yield curve – be related to economic activity. The question then is if taking active positions on the credit curve can attribute to the performance of a corporate bond portfolio.
The sensitivity of corporate bonds to the economic environment essen- tially depends on their time to maturity. In the short term, default risk for investment grade corporate issuers is primarily due to nonsystematic fac- tors, for example, cases of fraud or litigation. Over longer term horizons, conversely, systematic factors tend to have a higher impact on the default probability of corporate issuers. Changes in the economic environment and business risks in the sense of adverse industry trends or increasing competi- tion are major drivers of credit risk and hence for spreads in the longer term. Therefore, one would expect the spreads of long and intermediate investment grade corporate bonds to be more sensitive to indicators of economic activity than short-term bonds. This implies that credit curves should flatten when the economic outlook improves. Rising confidence in the corporate sector additionally spurs investors’ willingness to take on more spread duration. Consequently, in periods of spread tightening investors should expect credit curves to flatten. In other words, as Figure 4.23 illustrates, the slope of the credit curve and the level of credit spreads are positively correlated for investment grade issuers.
In Chapter 3, a positive relationship between different measures of finan- cial leverage and the level of corporate bond spreads was shown.
Additionally there is evidence for a strong impact of operating leverage and indicators for economic activity on corporate bond spreads. Clearly, rising utilization rates and a growing industrial production are a healthy environ- ment for the corporate sector. In this period, credit spreads should tighten across the credit curve. Since there is a high correlation between corporate bond spreads and various indicators for the state of the economy, for exam- ple, industrial production or capacity utilization, those factors might also hint to future changes of the credit curve. But, although the theoretical
argument is compelling, the correlation between the shape of the credit curve and macroeconomic variables is weak.
It has to be considered that indicators like industrial production are published only once a month and with a significant time lag. In other words, more timely available indicators of the market participants’ expecta- tions for future economic growth such as yield curve steepness should be able to explain variations of the credit curve better. As pointed out before, the yield curve usually experiences a bear steepening in the early stages of the business cycle and a bull steepening in the later stages of the business cycle, that is during recessions. While the first period is usually character- ized by tightening credit spreads and flattening credit curves, the opposite is true for economic downturns. Therefore the relationship between yield curve and credit curve changes depends on the stage of the business cycle.
At the beginning of an expansion one should expect a negative correlation between yield curve and credit curve steepness (Figure 4.24), but when economic growth slows down the correlation should turn positive (Figure 4.25).
Empirical evidence supports the hypotheses above. In the early stages of the economic expansion after the 1990/91 recession the yield curve steep- ened, driven by an improving economic outlook, and credit curves at the same time flattened. The higher confidence of investors in the ability of companies to generate sufficient cash flows led to declining risk premia for longer term corporate bonds. Conversely, during the 2001 recession, both
Figure 4.23 Slope of the 2s10s credit curve for A-rated US industrials versus spread levels in the period Jan. 1997 until Nov. 2003
Source:Merrill Lynch and Union Investment
y= 0.31x – 1.16 R2= 0.49
0 10 20 30 40 50 60 70 80 90
0 50 100 150 200 250
A industrials OAS
A industrials curve (2s 10s)
Figure 4.24 Slope of the credit curve for A-rated US industrials versus slope of the yield curve during the early stages of the
economic expansion after the 1990/91 recession
Source:Morgan Stanley and Union Investment y= – 0.23x + 44.89
R2= 0.33
–20 –15 –10 –5 0 5 10 15
160 180 200 220 240 260 280
UST 2s 10s (bp)
Credit 2s10s(bp)
November 1991–September 1992
Figure 4.25 Slope of the credit curve for A-rated US industrials versus slope of the yield curve during the 2001 recession
Source:Morgan Stanley and Union Investment y= 0.19x + 15.57
R2= 0.49
20 25 30 35 40 45 50 55 60
100 120 140 160 180 200
UST 2s 10s (bp)
Credit 2s 10s(bp)
Apr. 2001–Nov. 2001
yield and credit curves steepened. While government bond markets were driven by falling inflationary pressures and monetary easing, corporate bond investors shortened their spread duration, causing risk premia for longer term corporate bonds to rise.
In January 2003, the European corporate bond market established a new segment. France Telecom, Telecom Italia, RWE and Telefonica were the first companies to issue benchmark size Euro denominated 30-year bonds. Since then investors have ample opportunities to set up credit curve trades for Euro corporate bond portfolios, even at the long end of the curve. Analysis of the behavior of the 10s30s credit curve is difficult because of the limited history, but experience shows that the long end of the credit curve is tem- porarily influenced by the level of 30-year government bond yields.