Corporate bonds can be boring. The period between 2004 and 2006, for example, was particularly tedious. Euro-denominated investment grade credit spreads – the extra yield compared to benchmark government bonds – were stuck in a narrow range of just 0.32 percentage points.
In 2020, many credit investors seem to think that this uninspiring model is back. Corporate bond spreads have already been close to the bottom of their trading range for the past 10 years, and there appears to be nothing on the horizon to widen them. American and European growth are advancing rapidly, and vigilant central banks are behind the scenes, ready to curb volatility as soon as it appears.
However, such complacency is out of place. Credit spreads are unlikely to move sideways for a long time, as cycles have become much more volatile since the global financial crisis.
In the 30 years before the 2008 crisis, a typical cycle of credit spread lasted eight years. After an 18-month widening, the spreads tended to narrow for two years, then to move laterally in a period of low volatility that could last up to five years.
Over the past decade, however, cycles have shortened. The bear markets of 2007, 2011, 2015 and 2018 were quickly followed by bull markets, while the lateral trading periods became shorter.
To understand why the cycles contracted, investors must go back further in history, to the credit markets denominated in dollars from the 1970s. Like Europe, the United States also experienced long and prolonged cycles in the 80s and 90s. In the 1970s, by contrast, credit cycles in the United States were short and sharp – much like the cycles of the past 10 years.
Why did credit cycles return to 1970s models? Beards may be back, rockets may be in fashion again, but the most important parallel between the two periods for investors is the level of government bond yields.
Nominal yields were high at the time and have been low or even negative over the past decade; however, in both periods, real returns were very low. Between 1973 and the end of 1979, real yields on US bonds – measured by 10-year nominal yields minus the annual inflation rate – averaged minus 0.3%.
Between 1980 and 2010, real yields returned to an average of 3.5%, but over the past 10 years, this average has declined to 0.6%.
Real bond yields fell in both periods due to the central banks. Over the past decade, central banks have depressed nominal yields below inflation rates by reducing short-term interest rates and buying bonds through quantitative easing. In the 1970s, governments did the same thing by capping nominal bond yields.
But why should low or negative real bond yields make credit spreads more volatile? There are two reasons. First, low real yields increase the propensity of firms to borrow. When nominal returns are near or close to the level of inflation, companies need to generate only very low real returns to cover their debt costs. The borrowing increases accordingly. Although more leveraged balance sheets can be financed when yields are low, they make companies more vulnerable when the economy slows.
At the same time, low real returns influence the behavior of investors. Many bond buyers on both sides of the Atlantic buy fixed income assets to meet their liabilities. Insurance companies buy bonds to finance life insurance contracts, for example, while pension funds invest to provide retirement benefits. Both need positive real returns to generate the payments they have promised their investors. Therefore, as real yields in the government bond market decline, these investors opt for riskier assets – such as corporate bonds – to meet their needs.
The increased demand for corporate borrowing, as well as the increased demand for investors’ assets, may seem like a good fit. But when supply and demand are finely balanced, small changes in the environment can lead to big changes in credit spreads. Investors know that highly leveraged businesses are vulnerable, so as soon as the outlook deteriorates, they head out. Once the environment starts to improve, they come back just as quickly, to get the extra return from corporate bonds.
Instead of reducing the volatility of credit spreads, central bank policy is likely to increase it. In the United States, the short credit spreads of the 1970s did not return to the longer, more normal cycles of the 1980s and 1990s until Paul Volcker raised interest rates and made American yields positive once again.
The world’s central banks still seem far from their “Volcker moment”. As a result, 2020 could be a much more exciting year for global credit markets than investors think.
The author is responsible for research on fixed income securities at Société Générale