What Are Minicycles?
Before the global financial crisis (GFC), credit cycles typically lasted between five to seven years (Exhibit 1). However, since the GFC, more frequent periods of sharp spread widening followed by spread compression have occurred—what we refer to as minicycles. With these shortened cycles, spreads tighten and widen within only a couple of years. While the catalyst in each minicycle has been different, the underlying conditions that allow for this volatility in spreads have been the same.
Exhibit 1: Credit Spread Volatility Has Risen Post-GFC
Shaded areas represent periods of significant spread widening. Source: Bloomberg. Weekly data from 1 March 1991 through 28 May 2021. US Investment Grade Corporate = Bloomberg Barclays US Aggregate Corporate Index.
Understanding Credit Spreads
A credit spread is the difference in yield between a risk-free bond such as a US Treasury bond and another bond with the same maturity. Credit spreads often reflect market sentiment. In general, spreads are wide when investors are risk averse and demand higher yield as compensation, and narrow when investors are willing to take on risk and receive lower yield as compensation.
New Market Dynamics Fueling Minicycles
Shrinking liquidity: The lack of liquidity since the GFC has been the biggest factor contributing to these minicycles. The regulatory changes enacted in the aftermath of the GFC all but ended broker/dealer (B/D) proprietary trading, an important source of liquidity. Dealer inventories dropped from about $100 billion pre-GFC to about $25 billion today.
Growing demand: While liquidity was declining, the market was rapidly growing. Investor demand for US corporate bond mutual funds and exchange-traded funds (ETFs) has almost quadrupled since the financial crisis.
Result: The liquidity “pipe” has shrunk to a sixteenth of its size before the GFC. Moreover, liquidity is further exacerbated by an investor base that often moves in the same direction—buying when the market goes up and selling when the market goes down—and dealers that reduce their risk in sync with the herd. This is a recipe for dislocation and volatility in the markets and minicycles. We don’t expect this market dynamic to change in the near term.
Opportunities for Active Managers
While spread volatility has its challenges, it also creates opportunities for experienced active managers. This involves the willingness to give up higher current yield for a period to be able to potentially add more alpha over the course of the minicycle by recognizing critical points in the minicycle and acting tactically in both sector allocation and security selection. This means selling when spreads are at the tighter end of their historical range and buying at attractive/cheap prices when markets decline and spreads widen, providing liquidity when others are selling.
Although this means giving up higher current yield for a period, in our view, the potential to generate future returns through price appreciation when markets recover outweighs the lost carry. The key to capturing return potential during these short-lived minicycles is a disciplined valuation process: selling early when spreads are tight so you can provide liquidity (i.e., buy) during dislocations when spreads widen and valuations are cheap. To put it succinctly, you need to be early to be right.
Discipline, Research and Risk Management Are Key
We believe capturing opportunities through minicycles takes an active investment process, deep research, and a strong focus on risk management. Unlike passive managers who buy and hold, or active managers that chase gains, our investment teams analyze bonds, global economies, and markets to take a view on credit cycles and seek to take advantage of opportunities during periods of market volatility. This means reducing risk to be able to increase it later when the markets are in turmoil. This demands confidence in your research and the ability to stay disciplined on valuation and to be early, especially in selling.
The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.
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