In another example, Xcel Energy, the fourth-largest energy company in the United States, with a delivery network in thirteen states, outsources its IT functions to IBM.Why would Xcel Energy duplicate the capabilities of one of the largest information technology companies in the world when they can partner with them, receive their expertise and knowledge, and spend less for the service?

Let me cite one more example. I once worked with two partners who were in the mortgage banking business. In that business there are many players, each with a specialized role. There are closers who close a real estate transaction, lenders who loan the money, mortgage servicers who handle the loan, and mortgage custodians who manage the documents. This case involved mortgage servicers and mortgage custodians.

The servicers handle customer calls, accept and apply payments, and pay escrowed taxes and insurance for the mortgagee. The custodians file and store the documents and then, when they’re needed, ship them to appropriate locations—a cumbersome process considering the thousands of real estate transactions that occur every day.

A strong negative correlation between default rates and economic growth could always be expected, but during the economic crisis in the United States in the 1970s and 1980s a sharp increase of the default rates could not be observed. It was the economic slowdown in 1990, which was accompanied by extremely increasing default rates. The same acceleration of default rates occurred in 2001 due to a prolonged downturn of the economy, high political uncertainty after September 11, 2001, company accounting scandals, and aggregate weak credit fundamentals. Structural changes in the credit markets can explain the weaker than assumed relationship between the default rates and the economic cycle. This leads to the conclusion that the relationship between default rates and the spread level in the corporate bond market is a very complex one and that a good performance in the corporate bond market (tightening of credit spreads) can be consistent with increasing default rates at times where the market anticipates future decreasing default rates.

Interestingly, the relationship between equity and bond markets differs in deflation-risk periods and inflation-risk periods. In inflation-risk periods, rising inflation rates push up long-term interest rates, reflecting the fear that aggressive monetary tightening will depress future earnings and hence stock prices. Thus, in periods of rising inflation risk, government bond prices and stock prices tend to fall. In deflation-risk periods government bond prices and stock prices usually go in opposite directions, because fixed income markets benefit from the expectation of falling interest rates, while equities suffer from the worsening profit outlook and increasing default risk. Credit spreads tend to benefit from rising inflation because it becomes easier for companies to pay down their debt.

Deflationary periods usually lead to a spread widening across the whole credit market, hitting consumer-related industries the hardest. However, long-term interest rates seem to have a minor influence on fluctuations of credit spreads in the short term. Companies that borrow at a fixed rate are immune to changes in yields and spreads over the life of the borrowing. Yet, there is a refinancing risk, when debt has to be rolled over. Conversely, when companies borrow at floating rates, they are directly affected by changes in money market rates, which are primarily driven by monetary policy.

Monetary policy, too, appears to be an important indicator for corporate credit spreads. Let us assume that the economy is at the brink of deflation. Generally, deflation tends to be accompanied by a rise in bankruptcies. When corporate revenues and earnings are weak, highly leveraged borrowers have difficulties to meet their obligations. In this situation central bank easing paves the way for future economic growth. The traditional channels by which a lowering of the federal funds rate tends to stimulate faster growth in real and nominal GDP are: (1) lower debt cost of capital, (2) higher stock prices, (3) dollar weakness, (4) consumer durables, including automobiles, and (5) housing. Hence, it lowers the equity cost of capital and bolsters consumer confidence through the wealth effect. We see that  Baa credit spreads usually reach their peak when the Fed has done approximately two-thirds of the interest rate cuts.

Globally, the low interest rate environment in the first years of the new millennium has spurred investors’ interest in credit as a way to boost returns. However, one has to be aware that there is a correlation between the level of interest rates, the slope of the yield curve and credit spreads because both the yield curve and credit spreads reflect the state of the economy.

Since they are driven by expectations about the same underlying factor, the relation between the yield curve and credit spreads has an impact on top-down driven asset allocation and duration decisions.

In the past, credit spreads have been closely correlated with interest rates. There is typically a negative correlation between spreads and the level of interest rates. As interest rates increase due to an improving outlook for future economic growth and rising price pressure, credit quality tends to improve because firms have opportunities to strengthen their future earnings and cashflows. Similarly, a flatter money market slope (2 years–6 months) is usually positive for credit spreads because it indicates better economic conditions. In a difficult economic environment, such as at the trough of the recession, the money market curve tends to be very steep and credit usually underperforms treasuries, especially at the long end.

Although the close relationship between credit spreads and economic activity has held most of the time since 1950, the late 1990s witnessed a significant decoupling. Companies expected long-term stable and high growth rates, driven by new technologies like internet and mobile communication.

Coupled with a sustained rise in profitability, an idea strongly promoted by the Fed, this expectation caused companies to invest heavily and to leverage their balance sheets. In this period maximization of shareholder value was the credo of many managers. Despite strong economic growth credit markets punished the rise of financial and operating leverage that was observable across most industries and companies with widening credit spreads. Excessively high default rates in 2001 and 2002 showed that market participants anticipated the rise in systematic risk quite early. The sustained equity downturn and cases of fraud added to the woes of the credit markets.