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Industry Voices

Commentary: Investing across the cycle

Employing cyclicality as an opportunity for enhanced returns

Michael Donoghue

Credit availability and returns are often described as cyclical. For investors, that can mean more than higher and lower returns at varying times. There are clear entry points in the cycle when risk taking is richly rewarded and other times when it is punished. The key is to properly assess when to enter the cycle, and we have found that credit spreads can be a useful tool to guide the systematic management of credit exposure. The connection between spreads and forward returns has strengthened considerably post-2007. Structural changes and views toward risk have led to this connection.

Spreads tend to compress when economic activity is brisk and financial markets are accommodating — two factors that typically coincide. Spreads usually widen when default risk is perceived to be rising, as was seen from 2007 to 2008 and again in 2015 and 2016. This forward-looking attribute caused the high-yield market to be a leading indicator so much so that during the past three cycles, the high-yield market sell-off had occurred and was ending around the time defaults started to rise.


Before the 2007-2008 global financial crisis, lower-rated debt spreads (vs. Treasury yields) and forward returns showed very little connection. In the decade since the crisis, the spread-to-forward return correlation has been high. This correlation reflects the changing attitudes toward risk in a post-crisis world as seen through the eyes of regulators (Dodd-Frank, Basel III) and in institutional portfolios that allocated away from equities and toward non-traditional asset classes, which have been less correlated to stocks and bonds. These shifts led capital away from riskier assets and liquidity went with it. In a 2011 report about asset allocation, the International Monetary Fund suggested the "risk aversion of institutional investors has fundamentally changed ... in a structural and lasting way." The continuing illiquidity in risk assets, such as lower-rated high yield and equities, along with the ongoing investor interest in liability-driven strategies and less correlated assets (i.e., direct lending) is evidence that this forecast was correct.


Aside from specialists focused on distressed and restructuring trades, debt investors try to avoid defaults. Given that, default forecasts would appear to be a helpful tool for dialing risk up and down the portfolio. However, high-yield bond prices have shown a pattern of moving lower in anticipation of, not just in response to, deteriorating credit conditions. As seen in Figure 1, the data reveal that early action would be necessary if vulnerable portfolios were to be repositioned before their prices started to discount potential trouble.

Credit spreads

The last three downcycles were triggered by sector-specific crises that included mortgages, a U.S. government debt downgrade and energy troubles. These all had a broad impact on bond prices, as the mutual and hedge fund liquidations and portfolio derisking that accompanied each crisis led to a high correlation among high-yield credit spreads. Even though spreads moved together directionally, spread differences (or the spread between the spreads), tell a different story — that of the degree of relative expansion and contraction varying widely (as seen in Figure 2).

Given the cyclicality of credit, it seems reasonable to ask if mean reversion could result in a useful degree of correlation between spreads and forward returns. We have found that it can.


It is clear that since the global financial crisis, high-yield spreads have shown a strong correlation to forward returns. When applied to the dynamic rebalancing of high-yield portfolios, this understanding can be used to enhance returns and reduce volatility. This continued linkage is occurring because of the heightened risk sensitivity and reduced trading liquidity that followed the credit crisis. These appear to be structural or generational changes and, in our view, are likely to persist.

Michael Donoghue is president and John Mills is director of investor relations at Phoenix Investment Adviser LLC, New York. This content represents the views of the authors. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.