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.

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.