One of our recurring themes has been the changing profile of credit risk late in the business cycle. Simply put, there is more downside than risk when spreads are tight and underlying credit risk is increasing. This risk is amplified for long duration bonds or bonds that are the cusp between investment and non-investment grade ratings.
A review over the last five years provides a history of the specific risks faced by credit investors. The risks in a low spread environment are great because any macro shock will significantly impact yield compensation. For example, the earnings and commodity price compression down draft of mid-2014 to mid-2016 caused a multiple increase in spreads. A decline in earnings with commodity prices also pushed up US high yield defaults and the ratio of downgrades to upgrades.
Of course, this spike passed and spreads tightened to extremes only to go through another spread spike as growth expectations slowed in the fourth quarter of 2018. We are now seeing increase in defaults and downgrades.
January was a great month for credit investors with spreads tightening significantly; however, the slower trends in downgrades and defaults will not show the same quick fluctuations. Even if the Fed limits rater increases in 2019, the damage of earlier increases will impact companies rolling over debt. Our view is that this is a good time to switch credit risk premia for other premia that are more defensive and are based on relative (long/short) risk performance.