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.