The End of the Credit Cycle?

AAM Corporate Credit View (Fall 2015)

The End of the Credit Cycle?

By Elizabeth Henderson, CFA
Director of Corporate Credit

Elizabeth Henderson


Volatility remained high in all markets with investment grade credit spreads widening 23 basis points (bps) versus Treasuries in the third quarter. The main driver of this widening was falling commodity prices in response to continued weak data from China and global growth concerns.

Repricing Risk

The Federal Reserve’s decision and communication led to investor consternation in the latter half of September. The prospect of higher rates concurrent with the increased risk of slower global growth resulted in a repricing of risk.

This was most evident in the high yield market with spreads widening 153 bps in the third quarter. Investors pushed back in the new issue market, demanding much higher yields (e.g., Frontier Communications, Altice, Olin). In investment grade, we witnessed issuers pulling deals from the market after poor investor response as well, a dynamic we have not experienced in some time. The CLO (Collateralized Loan Obligation) market has also suffered with credit quality erosion and market volatility impacting pricing and originations. Appreciating the importance of credit availability and creation to the health of the credit market and economy, we are concerned with these events.

We cited the increased risk of fallen angels in last month’s Corporate Credit View (“Fallen Angels Expected to Increase”). The market recognized this risk in the third quarter, repricing many BBB rated credits, with $211 billion of debt across 56 investment grade issuers trading like high yield credits[note]Stephen Antczak, CFA, “Fallen Angels: How many, how to cope,” Citi Research, October 2, 2015[/note].

Market Vulnerabilities

 The first signs of credit contraction cause us to increase the top end of our range for spreads. We had entered 2015 with an expected range of 120-175 bps (Exhibit 1). Considering the change in quality and duration of the Barclays Corporate Index since prior points in the cycle, as well as corporate fundamentals today, we have modeled downside risk to be 225 bps.

However, risk is skewed to the downside due to the difference in liquidity conditions (“The Perfect Storm? Fixed Income Portfolio Management in a Reduced Liquidity Environment”). In the Royal Bank of Scotland’s (RBS) September Survey 79% of investors believed that we are moving to a structural phase of high asset price volatility. As the survey results show, this was the second biggest fear among investors (first being China). RBS states that “declining liquidity and an increase in herding may exacerbate volatility during times of stress, with the IMF (International Monetary Fund) highlighting an increase in correlation among major asset classes and between fund positions, since the crisis.”[note]Alberto Gallo, “The Silver Bullet|Credit nearing breaking point: Stay Short,” Royal Bank of Scotland, September 30,   2015.[/note] Regardless of fundamentals, we believe the market needs to reprice for this level of volatility, hampering a return to 120 bps.

Exhibit 1: U.S. Corporate Investment Grade OAS

AAM Corp Credit Fall-2015 1

Source: Barclays, AAM as of 9/30/2015

We believe BBB rated credits away from the Energy and Basic Material industries are particularly vulnerable, if the credit cycle has ended and spreads widen. The spread differential (i.e., basis) of A and BBB rated Industrial credits has increased due to commodity related sectors, as the risk premium for other BBBs (excluding Energy and Basics) has not widened (Exhibit 2).

Exhibit 2: BBB-A Industrial Rating Basis, excluding Energy and Basics

AAM Corp Credit Fall-2015 2

Source: Barclays, AAM as of 9/30/2015

Additionally, cyclical sectors away from commodities have performed in line with more defensive sectors. We believe the risk premium for economically sensitive sectors could also widen with sectors within Consumer Cyclicals particularly vulnerable.

Exhibit 3: Spread Changes for Sub Sectors YTD

AAM Corp Credit Fall-2015 3

Source: Barclays, AAM as of 9/30/2015

We would expect widening in Financials as well.   They have outperformed year-to-date, but would be impacted in a credit correction, as increased credit defaults would be a drag on earnings and capital levels. We are watching bank lending standards and credit loan growth closely for additional signs of credit contraction. We note the third quarter loan growth was less than half the rate realized in the second quarter due to a slow down in commercial and industrial (C&I) lending.

Exhibit 4: Finance – Industrials Spread Difference

AAM Corp Credit Fall-2015 4

Source: Barclays, AAM as of 9/30/2015

The banks continue to operate in an opaque regulatory environment. A draft form for TLAC (Total Loss Absorbing Capital) is expected to be released by the Global Financial Stability Board before the G20 finance meeting in November.  However, the Fed and OCC (Office of the Comptroller of the Currency) are expected to tweak it for the U.S. system, which is expected to take longer.  Therefore, debt issuance requirements (needed to increase capital levels) may become clear later this year with a four to six year implementation period.  We believe the long implementation timeframe is manageable, thus we do not believe this will be a systemic issue or stress on the system.


We are in the late stage of the credit cycle, and signs are emerging that we may have reached the end. If that proves true, we would expect spreads to widen and rating actions to become more punitive. Companies have increased leverage at a time of slowing earnings growth to increase shareholder returns.  Regardless of whether we are at the end of the cycle, we expect this credit deterioration to continue to be a headwind for spreads and an impetus for rating downgrades.  In the past, economic cycles have lagged credit cycles by approximately 12 to 24 months. Therefore, we would not expect management behavior to become creditor friendly until the risk of a recession increases. Although spreads have widened, this is a time to remain defensive and selective.  As growth forecasts are revised lower and credit appears to be contracting, we are growing increasingly more cautious.

For more information about AAM or any of the information in the Corporate Credit View, please contact:

Colin Dowdall, CFA, Director of Marketing and Business Development

John Olvany, Vice President of Business Development

Neelm Hameer, Vice President of Business Development

Disclaimer: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made during the past year is available upon request. Past performance is not an indication of future returns.

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