Take the lead: Understanding credit cycles

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Advisors: Help educate your clients on the variability of credit cycles, including the potential risks and where opportunities lie.

The background

The concept of the credit cycle is ambiguous. Not everyone talks about it in the same way, and not all parts of the economy are at the same stage of the cycle at the same time. At a basic level, the credit cycle centers on the vulnerability of borrowers and the compensation that lenders receive for extending credit to those borrowers.

How investors can approach credit cycles

  • Understand the risks for bond holders.

At the beginning of a cycle, lenders will typically demand higher yield premiums, better collateral and stricter deal terms for loans. But over time, the pendulum of influence swings toward borrowers, deal terms loosen, yield premiums shrink and there’s more money available to lend. When economic shocks hit, the likelihood of default increases for more vulnerable borrowers.

  • Be aware of how credit cycles vary.

Different sectors and industries are always at varying points in their cycle, and an end in one sector does not mean an end in all. Sometimes vulnerabilities in a particular sector are so large that they infect other sectors, but this is not always the case.

  • Differentiate between the consumer and corporate sectors.

U.S. consumers have been reducing their overall level of debt since 2008. The vast majority of consumer debt is mortgage debt, which has been right-sized and refinanced at low interest rates.

  • Be prepared for the end of a credit cycle.

The end of a credit cycle doesn’t come quickly — but the reaction in markets can be abrupt and jarring. The time for investors to be defensive is when risks rise, asset valuations are elevated and the extra compensation that investors receive for taking risk is low. It’s important to minimize exposure to more vulnerable sectors and industries where the risk outweighs the potential reward.