- Credit markets tend to lead stock markets at major turning points
- Spread between corporate and government bonds widening
- Banking is the one sector that remains bondholder-friendly
With traditional financial market lead indicators such as the bond yield curve being subject to manipulation by central banks through their quantitative easing programmes, might corporate bond (credit) markets be a better signal as to where we sit in the business cycle?
Put another way, with asymmetric risk in corporate bonds - that is, downside risk from default, but limited upside - could corporate bond markets be the bloodhounds that can detect a change in the business cycle?
CORPORATE HEALTH DIAGNOSES
This is an idea worthy of some contemplation for all investors in risk assets at present, for two reasons: first, and often unremarked, corporate bond markets in the US have been in a bear market since June 2014, and have dragged European corporate bond markets with them in 2015.
Over the same period stock prices, although faltering at times, have continued to rise. As a result, equity and corporate bond markets seemingly have different interpretations of the health of the corporate sector.
Secondly, history has shown that corporate bond and equity markets have exhibited a strong correlation, since both asset classes benefit from positive economic momentum.
However, in the final stages of a business cycle, as animal spirits become overheated and equity-friendly activity (share buybacks, debt-funded merger and acquisition activity) accelerates, the two markets begin to diverge, with credit often turning down before equity markets.
Over the past 18 months credit markets have been definitively signalling caution, as shown by the widening of the credit spread (see chart, click to enlarge). The credit spread is the additional yield on offer above that of an equivalent maturity government bond, which compensates investors for the additional risk they are taking.
The increased spreads suggest that the credit cycle - a measure of the ease and ability of companies to borrow for debt refinancing, capital expenditure and other spending - has turned.
At present, it would seem that the US investment-grade bond market in particular has been saturated by debt issued to finance M&A activity and stock buybacks - classic late business cycle corporate activity, as mentioned earlier.
Within high-yield, while problems are mainly in specific sectors such as commodities, the distress ratio - the proportion of bonds trading below 80 pence in the pound - is increasingly spreading to other sectors as well.
Hence, both from a corporate activity perspective and in terms of defaults, corporate bond markets are sending a strong signal that the cycle has turned.
A WHALE OF A MARKET
A little-known fact, and one which all investors need to be aware of, is that today's corporate bond markets are much bigger in size than in previous years, as companies have taken advantage of continued low interest rates to fund their activities.
In the US, according to the Securities Industry and Financial Markets Association (SIFMA), there was $8.2 trillion (£5.4 trillion) of corporate bonds outstanding at the end of the second quarter of 2015, compared to $12.7 trillion in the government bond market.
While most obsess about the next interest rate tightening cycle in the US, financial conditions have already tightened in the credit markets - and currently they are sending quite worrying signals for equity markets.
A final thought: credit markets tend to lead the stock markets at major turning points. However, the turn in the credit cycle does not necessarily imply a simultaneous change for equities.
The latter could continue to rise for months or even years, as in the late 1990s, when stocks signalled growth in the economy and profits while bonds indicated trouble ahead.
As bond managers, our portfolios reflect the turn in the credit cycle. The one sector that remains bondholder-friendly, presenting good opportunities due to continuing regulatory changes, is the banking sector.
In addition, we put cash to work selectively as value emerges, with large, non-cyclical industrial companies, in our view, still representing sensible investments.
Jenna Barnard is co-head of UK retail fixed income at Henderson Global Investors.