Figure 3: In the Late 1990s, a Flat Curve Eventually Gave Way to Wider High-Yield Bond Spreads.


Investor psychology tends to play a role as well. Investors tends to chase performance. After many years of strong performance in the early stages of an economic recovery, typically by the mid-to-late stages of an economic expansion, demand for high-yield debt remains strong. After the central bank tightens policy and flattens the yield curve, the only option for placing these additional funds is in lower and even lower credit quality. As such, yield-curve flattening tends to be associated with a further tightening of spreads. It’s only later, when economic activity slows in response to the tightening of monetary policy (often about 1-2 years after the tightening cycle ends), that the economy begins to slow and default rates begin to spike, leading credit markets to seize up.


Source: Bloomberg Professional (GB3, USGG30YR, LF98OAS), CME Economics Research Calculations Figure 4: The Current Cycle Looks a Lot Like 2006 or 1997.


A widening of credit spreads also has significant implications for the equity market. Corporate buybacks of equity are a big source of demand for stocks. Essentially, corporations either use current earnings or issue debt to buy back equity, reducing the number of outstanding shares and bidding up the share price. Borrowing funds is easy when debt is cheap but when spreads widen, this avenue of funding equity buybacks becomes prohibitively expensive. Moreover, wider credit spreads are closely associated with slower economic growth and falling corporate profits, also cutting off that avenue of funding of share buybacks.


Source: Bloomberg Professional (GB3, USGG30YR, LF98OAS)


Why the delayed reaction? In the early stages of an economic recovery, life is easy for high-yield investors. Spreads over Treasuries are typically wide and yield curves are steep, giving them tremendous interest rate carry over their cost of funding. As the economic recovery advances and the central bank tightens policy, the yield curve flattens, removing one of the two sources of positive carry. As such, going out further on the curve is no longer an option for generating additional returns. For investors who wish to generate higher returns, a flat yield curve leaves only the possibility of going downward in credit quality.


AFTER THE CENTRAL BANK TIGHTENS POLICY AND FLATTENS THE YIELD CURVE, THE ONLY OPTION FOR PLACING THESE ADDITIONAL FUNDS IS IN LOWER AND EVEN LOWER CREDIT QUALITY.


25 | ADMISI - The Ghost In The Machine | September/October 2019


Page 1  |  Page 2  |  Page 3  |  Page 4  |  Page 5  |  Page 6  |  Page 7  |  Page 8  |  Page 9  |  Page 10  |  Page 11  |  Page 12  |  Page 13  |  Page 14  |  Page 15  |  Page 16  |  Page 17  |  Page 18  |  Page 19  |  Page 20  |  Page 21  |  Page 22  |  Page 23  |  Page 24  |  Page 25  |  Page 26  |  Page 27  |  Page 28  |  Page 29  |  Page 30  |  Page 31  |  Page 32