As the length of the current credit cycle approaches the nine-year average of the past few cycles, there are signs that change is in the wind for the U.S. high-yield market. Debt issuance appears to have increased, while defaults are rising. If history is our guide and the credit cycle is indeed shifting, it likely will coincide with an economic recession in the United States, historically the worst time to own lower-quality credits. It is not surprising, then, that investors want a better understanding of where we are in the credit cycle.
The credit cycle reflects the expansion and contraction of credit as we move through three broad economic phases: recovery, expansion, and downturn. While clearly we have recovered from the last contraction in credit and a pullback in the economy, we are not yet at a credit downturn. Credit downturns involve reduced bank lending, credit-spread widening, and increased defaults, generally during a period of economic recession. While defaults have increased, bank lending continues to expand, credit spreads continue to narrow, and typical conditions for a U.S. recession—the sequence of robust growth, excessive borrowing, and aggressive monetary tightening—do not exist.
The primary areas of concern today—substantial debt issuance and defaults—are less a function of aggressive risk seeking corporate behavior and more related to refinancing at historically low rates and problems specific to the energy and metals/mining sectors.
There is little sign of a credit crunch in terms of bank lending. According to a report from the U.S. Federal Reserve (Fed), U.S. commercial and industrial loans grew 8.4% in the first half of 2016, after growing 10.3% in 2015; commercial real estate loans increased 10.5%, versus 9.9%; residential real estate loans increased 2.7%, versus 1.1%; and consumer loans grew 7.6%, versus 5.7%. Lending growth and availability of credit continues to expand, despite the fact that financial institutions are more heavily regulated than in the past several credit cycles.
In addition to continued bank lending, narrowing credit spreads suggest lenders are comfortable with the credit metrics of lower-quality companies. As charts 1–2 illustrate, spreads of high-yield debt and, separately, ‘CCC’ rated bonds indicate a willingness to lend and availability of credit.
Chart 1. Spreads on Non-commodity ‘CCC’ Rated Bonds Have Remained Within Their Multiyear Range…
Source: Deutsche Bank.
Past performance is no guarantee of future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Chart 2. … While Spreads on the Broader High-Yield Sector Also Have Held Near Historical Averages