The rating agencies have been criticized for being too slow to react to changes in the credit quality of an issuer, leading to serially correlated rating patterns and limiting the value of ratings as a risk management tool. As a reaction, Moody’s decided to put its rating process under review, and acquired KMV to be able to provide investors with additional, marketbased assessments of an issuer’s credit quality. The feedback from market participants was surprising. Since investors themselves tend to use spreads and spread volatility as indicators for credit risk, the vast majority does not want Moody’s or the other rating agencies to switch to a more marketbased approach when assessing the credit quality of an issuer. There is really a need for, according to the feedback, more transparency with regard to the rating process. This would allow investors to use rating agency information in their risk management most efficiently.

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.

The following paragraph will deal with default rates because they are of central importance for high-yield investors. We compare the three major default peaks since 1920. Default rates have to be distinguished between “issuer-weighted” and “dollar-weighted”. The increasing amount of Fallen Angels in 2002 resulted in a sharp increase of the “dollar-weighted” default rate.

High-yield spreads tend to lead default rates, which means that a tightening will occur prior to a fall in the default rate because market participants will already anticipate the future development of the default rate. This relationship broke down in 2002 for a couple of months due to the large divergence of the “dollar-weighted” from the “issuer-weighted” default rate. As we can see cumulative default rates tend to increase progressively with a decreasing rating class.

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.

Similar to the level of interest rates itself the slope of the yield curve also is an indicator for the economic environment. Generally, the slope of the yield curve is seen as a good proxy for future economic growth and corporate profits.

Steep yield curves imply that future rates are expected to be higher than at present. Asteep 2s10s slope and a further steepening of the 2s10s slope in the past often have been followed by positive excess returns of corporate bonds. Usually, one observes a steepness in this part of the curve at the end of a recession and at the start of an expansion. When the expansion finally materializes the curve flattens, and inflation concerns cause central banks to raise interest rates. In this environment, credit usually suffers, and investors should be particularly cautious when overweighting cyclical credits.

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.