Submitted by CreditTrader
My thoughts on the long-term debt cycle (trying to ignore the impact of
the credit crisis specifically). The idea is that if you follow the
cycle of the relationship of debt to equity, a better understanding of
how debt and equity lead and lag one another through the cycle.
Furthermore, I think it can highlight how risk aversion at the tails
may put a floor on spreads in the short-term and implicitly a cap on
equity valuations. This chart can be done in P/E ratio-land (but given
the current silliness in valuations provides little insight), though we
suggest trying to build the same chart with the Shiller longer-term
P/Es (hint hint).
1) After 3-4 years of The Great Moderation and an impressively easy credit cycle helped by securitization-demand, credit spreads started to crack before equity did as over-zealous PE firms started to ravage corporates (driving leverage up)...
2) This (as it usually does in the credit cycle) leads from equity outperforming credit to both credit and equity deteriorating as that termed out debt (not delevered) comes back to roost and drives WACC up, forcing equity valuations down (think structural models and the implicit rise in business risk / asset vol)...
3) As the credit cycle turned down we see credit leading equities down as the forces in (2) take hold and a vicious circle of deleveraging 'expectations' takes hold (whether by bankruptcy or actual debt paydown). These expectations may or may not come to fruition during this period (they did not) as we saw...
4) The spike to cycle wides in IG credit spreads remained somewhat linear with S&P 500 levels from the past ten years but the onslaught, breaking far beyond the dot-com/Enron cycle wides/low valuations. However, the credit market remained highly levered and defaults mounted but did not explode as we saw a virtuous cycle of government-provided liquidity allow distressed firms to either a) refinance/term out debt, b)receive explicit govt support, and/or c) receive implicit govt support. This led to...
5) Spread compression in IG credits as their term structures shifted from inverted to upward-sloping once more as rather than deleverage, corporates were able to term out debt, renegotiate secured lines down to unsecureds, or see that debt guaranteed for a short-term. This provided an optical improvement in risk over a medium-term horizon (think 3-5Y perhaps) and so we see the credit term structures now very steep in 3s5s and 5Y (the most liquid maturity) having tightened notably.
However, the point of all this is that the light red oval/cycle is what we expect as the new normal as we enter the next downturn. Credit curves are pricing in a significant double-dip recession via their steepness and it would appear that the debt-equity markets are reverting to a 2001 risk-aversion perspective from the chart.
The shift (3) in the chart is the key, as is the second chart comparing VIX to spreads where we see the clear regime change between a VIX<~20 and >~20 and its lack of correlation and clear dependence respectively. While VIX remains at the higher end of the old regime (and the bulls implicitly call for more compression and further rallies to normalcy), we suspect that credit and equity vol will re-emerge as strongly linked in the next credit cycle and that it will occur sooner than many believe.
The cognitive bias we have been provided by the extreme drops in asset valuations has set a more 'careful' or risk-averse mindset into investor's framing and while we can point to how far VIX has come from its highs, spreads from their wides, equity from its lows, TED spreads from their wides, it is worth remembering that before the 1987 crash there was NO smile in option vols (tail risk aversion) and while it would appear that this liquidity-driven rally for the ages can continue forever on the back of the Fed/TSY's printing press, we suspect that risk premia are in a new 'riskier' regime and we are at the low of that new regime, rather than at the higher end of the old normal regime.