Disentangling Cycles from Time
Deep into the expansion phase of an economic cycle, the classic pattern involves Fed tightening, yield-curve flattening, rising rates, and tightening credit spreads. However, cycle lengths can vary greatly, and this has implications for bond investors.
At 94-months old, the current economic expansion is already the third longest in U.S. history, and there is no end yet in view. Leading economic indicators, such as the positive slope of the yield curve and new orders, point to continued economic activity ahead. And while the Fed is slowly raising rates, banks have yet to tighten lending standards on commercial and industrial loans to businesses, so it is still early days for the Fed’s transmission process (see Figure 1).
Figure 1 – Net Percentage of Domestic Banks Tightening Standards for Commercial and Industrial Loans to Small Firms (Recessions Shaded)
Sources: Thomson Reuters, Datastream. Data as of 4/11/17. Last available data point, 2/6/17. Data calculated by the U.S. Federal Reserve Senior Loan Officer Opinion Survey.
As a result, no one can say how much longer the expansion will last. The 1991-01 expansion lasted 120 months, eclipsing the prior 1961-69 record at the time by 14 months. And, the 1961-69 expansion was 26 months longer than the previously longest expansion ever, which took place in 1938-45.
What does all of this mean for bond investors? Since below-average spreads may persist as long as the fundamentals hold up, one of the best ways to receive a relatively consistent income stream may simply be to avoid defaults (Figure 2).
Figure 2 – Spreads May Stay Tight as Long as the Fundamentals Hold Up (Recessions Shaded)
Sources: Thomson Reuters, Datastream. Data as of 4/11/17. Last available data point, 3/31/17. Data calculated by Thomson Reuters and Moody’s. The High-Yield Option Adjusted Spread is represented by the BofA Merrill Lynch HY Master II Option Adjusted Spread to Treasurys. The BofA Merrill Lynch Option-Adjusted Spreads (OASs) are the calculated spreads between a computed OAS index of all bonds in a given rating category and a spot Treasury curve. An OAS index is constructed using each constituent bond’s OAS, weighted by market capitalization.
By combining a deep-research process with strong risk-management capabilities while seeking to avoid the riskiest bonds, a strategy with relatively low default rates may help reduce the volatility of a portfolio and potentially improve its risk-adjusted performance over time.
Spreads are below average, but with a growing economy, opportunities in credit still exist.
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All investments are subject to market risk, including possible loss of principal. Diversification cannot assure a profit or protect against loss in a declining market.
Bonds, sometimes referred to as fixed income investments, are IOUs issued by governments, government agencies, or companies. When purchasing a bond, the investor lends money to the bond issuer. In return, the issuer agrees to repay the purchaser with interest. A bond’s prices are inversely affected by interest rates. The price will go up when interest rates fall and go down as interest rates rise. Bonds are subject to credit risk and interest rate risk.
A yield curve is a curve on a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity.
A credit spread is the difference in yield between two bonds of similar maturity, but different credit quality.
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