CHAPTER
FIVE
MACRO-ECONOMIC DYNAMICS AND THE CORPORATE BOND MARKET

STEVEN I. DYM, PH.D.

President
Mariner Capital Partners

Perhaps more than any other sector in the capital markets, corporate bonds are profoundly affected by the dynamics of the macro-economy. Movements in interest rates, inflation, yield-curve shape and corporate earnings are all driven in large part by the business cycle. These variables, and their volatilities, all play a role in the determination of corporate bond yields and prices, and their derivatives. This chapter explains these various roles and their interactions. It begins with a short synopsis of practical macro-economics.1

THE MACRO-ECONOMY

Real Gross Domestic Product, or GDP, represents the total value of goods and services produced in a country over a given time period, usually one quarter. It is typically presented as a rate of change from the previous quarter—a growth rate—and annualized. This is convenient, as interest rates and inflation are typically expressed on an annual percentage basis as well. It is “real” in that the inflation rate is subtracted from the raw estimate.

The amount of GDP that the economy is capable of producing is known as potential GDP, or potential output. It is a theoretical measure because, by definition, it is not observed. Yet, it is extremely important, and here’s why. A country’s potential GDP is determined by its resources—labor, physical capital, and natural. If actual GDP is below potential then some of these resources are not being fully utilized. Rather, they are underemployed (or unemployed, if a person is not working at all, yet willing), a deadweight loss to society. The difference between actual and potential GDP is the GDP gap.

Why do investors, particularly those involved with corporate bonds, care about real GDP, potential GDP, and the GDP gap? A few good reasons are:

• Movements in GDP are highly correlated with corporate revenues. Indeed, it is almost definitional—output must be produced, and companies do the producing.2 More revenue implies an enhanced ability for firms to service their debt, hence reduce the risk of default (and, resultantly, lower risk premia on corporate bonds, to be discussed later). A caveat, however, is in order. Debt service is met from net, not gross, revenue. A firm’s revenue may be consumed by production costs (e.g., labor) and fixed (e.g., rent) costs. This makes the correlation imperfect.

• Interest rates are determined by the supply and demand for credit. In turn, the supply of credit—via household savings, the ultimate (domestic) supplier of credit—and demand for credit—by corporations (and governments)—are both profoundly influenced by the level of GDP and GDP growth (plus expectations for such).

• At least in the short run (say, over a business cycle), the rate of inflation is an outgrowth of the size of the GDP gap. Demand for input (labor, materials and capital goods) is determined to a great extent by actual GDP, while input supply reflects the economy’s potential. The nexus of this supply and demand goes a long way in explaining inflationary pressure or its absence.

• The central bank’s insertion and removal of liquidity is largely a function of the GDP gap. Directly, the central bank is concerned with under (or over) utilization of the country’s resources, particularly labor, as measured by the GDP gap. Indirectly, the bank seeks to prevent inflationary (or deflationary) pressure, likely a result of the gap. And since the central bank’s policy tools work through the financial markets, corporate bond investors take notice of and, indeed, try to anticipate the bank’s actions.

Clearly, then, corporate bond investors are profoundly interested in what makes GDP, hence the GDP gap, tick. Unfortunately, we’re not quite sure. We have a decent understanding of relationships among macro-economic variables, but no one is totally confident about the drivers of macro-economic activity. So, let’s just review what we know, and point out the major differences of opinion. Clarity about what is not known is as important to an investor as confidence in what is known.

The “product” in GDP is sold to demanders of that product. We divide all the demanders, or purchasers, into what is referred to as aggregate demand sectors:

Households. Also known as consumers, households purchase the majority of produced goods and services. It would be hard to experience any significant GDP expansion or contraction without concomitant movements in consumer spending. Part of consumption adds to potential GDP even as it adds to actual GDP. Spending on education is an example since, at least theoretically, it contributes to the person’s productive capabilities. Consumer spending on discretionary items is sensitive to the business cycle, hence volatile, unlike spending on necessities. A relatively small, but very volatile part of household expenditures is for homes—not the furnishings or appliances, but the house itself. The percentage of household disposable income not spent on goods and services is defined as the (personal) savings rate, where disposable income is measured as household income less taxes.

Businesses. Purchases by companies of materials, payments of wages and benefits to workers, rent to building owners or interest to lenders are not counted in GDP; these are already represented in the prices of goods and services paid by the ultimate user. Rather, included are capital expenditures, such as on plant, equipment, and software. Importantly, these expenditures, referred to as Capex, add to the economy’s potential GDP as well as to actual, because they enhance each worker’s ability to produce output. Another way to say this is that Capex adds to GDP and simultaneously improves the country’s “productivity,” typically defined as the ratio of aggregate output to labor input. Separately, a pile up of inventories, due either to disappointing sales or intended stock accumulation, increases GDP—after all, the goods have been produced. A subsequent drawdown of stocks will reduce GDP. Capital expenditures and inventories account for a relatively small portion of the level of actual GDP. But because of their sensitivity to the economy’s fluctuations, they (and housing) tend to account for a disproportionately high fraction of changes in GDP.

Governments. Spending by state and local governments is about twice as large as that of the federal government. Both units tax and spend for current consumption as well as capital projects (e.g., schools, bridges), the latter contributing to the country’s potential GDP. When the federal government increases spending (or reduces taxes) specifically to raise aggregate demand and, hopefully, stimulate the economy, it is termed fiscal policy. Note that some government programs (unemployment insurance is the most well known) kick in without new legislation when the economy is weak. These are known as automatic stabilizers. It is crucial not to confuse the central government’s spending on goods and services with the central bank’s “spending” on financial instruments (monetary policy)—the former enters the “real” economy, the latter winds its way through the financial markets. We’ll get to this crucial distinction soon.

Foreigners. Any portion of the above spending that is purchased from foreigners—that is, imports—results in a reduction in aggregate demand, hence lower GDP. Any purchases by foreigners of U.S. produced goods and services add to aggregate demand. For a given level of GDP, an excess of businesses capital expenditures over household savings must be matched by an excess of government receipts (mainly taxes) over government spending. If the former is larger than the latter, a trade deficit (more imports than exports) must result. All the more so if government spending exceeds receipts. Conversely, if household savings exceeds capital expenditures, and the difference is less than the difference between government spending and taxes, a trade surplus is the result.3

Here’s the bottom line. An increase in demand from any of the sectors elicits production of goods and service. GDP increases. Producers use materials, purchasing them from other firms, which in turn produce more. Firms hire labor, who spend their earnings. Physical capital is more heavily utilized, prompting additions to the capital stock. In short, a positive dynamic is introduced into the economy. The GDP gap narrows, as resources are more fully employed. Depending on the degree of GDP growth or, equivalently, the extent of the GDP gap narrowing, inflation may be sparked. Material supplies become tighter and the labor market strengthens, both putting upward pressure on production costs.

It’s a nice, straightforward story. However, be aware that there is no general agreement among economists, or among market participants, that the story is true. The theoretical underpinnings of the disagreement are complex. Nevertheless, corporate bond investors need some appreciation of the issues.

Briefly, this is a “demand driven” view of the macro-economy. Economic activity is driven—that is, determined—by aggregate demand, or the sum of spending by the above sectors. If demand is weak, economic slack—the GDP gap—results. If spending strengthens, resources are required, hence purchased and employed; the GDP gap narrows. Aggregate production thus, responds to demand. Others would argue that this analysis ignores a basic principal of economics—the price mechanism as the equilibrator of supply and demand for goods and services. Similarly, the price of labor (wages plus benefits) should adjust until labor supply meets demand for workers by firms based on their productivity. (Further, interest rates equilibrate supply and demand for capital.) Now, this may not hold instantaneously but, the argument goes, macro-economic variables approach these equilibrium values over time. The upshot of the alternative argument is this: As long as fundamental economic measures—such as the household savings rate, labor market realities including productivity and unemployment insurance benefits—are unchanged, real GDP and, hence, the GDP gap will not exhibit lasting change. In particular, an increase in government spending will not have long-term effects, as households will reduce their spending in recognition that they will ultimately be taxed. Government demand “crowds out” private sector demand.

Regardless of whether aggregate demand determines macro-economic activity or, in the alternative view, is in some fashion (jointly) determined by it, it is certainly an indicator of actual GDP. If there is no spending, there is obviously no production. Hence, understanding the dynamics of and predicting aggregate demand does the same for GDP. That explains the strong interest of corporate bond investors in the demand sectors enumerated above.

CORPORATE PROFITS

It would be too easy to say that corporate profits, in the aggregate, rise and fall with macro-economic activity. Rather, corporate revenue follows the macro-economy’s path. Indeed, this is almost an identity, since GDP measures the output of goods and services, and corporations produce that output. Corporate bonds, however, are serviced from profits,4 not revenue, so that is our interest here.

Clearly, more GDP means more sales or revenue. If the company is producing at a profit, the higher level of sales translates into greater profit. Interest and other debt service are more easily covered, bondholders feel more comfortable, and credit-spreads narrow (more on this later). All good for corporate profits, but note the following possibility. The greater level of economic activity, however, pushes the economy closer to its potential. As explained above, this may well raise production costs. At some point, inflation is precipitated. If material and labor costs rise faster than output prices, corporate profit margins are eaten into (in the extreme they turn negative), reducing debt coverage. Investors then fear a greater probability of default, and corporate bond credit-spreads widen.

INTEREST RATES

What we’ve discussed until now is known as the real side of the economy. We need an understanding of this for its own sake, as a determinant of corporate revenue and profits. But, in addition, macro-economic activity is intimately related to the financial side, which directly impacts corporate bond investors.

What determines interest rates? Fundamentally, supply of and demand for credit. From a macro-economic perspective, credit is made available by households consuming less than they produce. You can think of this in two ways, one the obverse of the other. Goods and services are produced by households (who are the ultimate owners of their own labor and the economy’s physical capital and natural resources). The portion which they do not consume is made available to others (businesses, governments, foreigners) to consume. But they must pay it back, with interest. Alternatively, households receive income for their productive efforts, in the form of wages, profits, and rent. Rather than spending it all, they lend a portion to borrowers (who purchase the “left over” goods and service produced by households), and expect to be repaid, with interest. The more credit households make available to borrowers, that is, the more they save, the lower the interest rate borrowers must pay. The more credit borrowers require, the higher the interest rate necessary to elicit more savings from households.

THE CENTRAL BANK

What we’ve drawn now is the big picture. There are lots of details, only some of which are relevant to corporate bonds. A major one is the role of the central bank. Where does it fit in?

The central bank has a monopoly on liquidity creation, at least in the short run. Liquidity, in this context, refers to the means of effecting transactions. Every economy requires liquidity. Indeed, the greater the pace of economic activity, the more liquidity required.5 This monopoly is what gives the central bank the ability to set (short-term) interest rates. Here’s how it works, in a nutshell. Let’s focus on the central bank in the United States, the Federal Reserve (the Fed). Central banks in other (industrialized) countries operate similarly.

Suppose the Fed observes real GDP growing substantially below its potential. Unemployment is uncomfortably high (and inflation not an issue). The central bank enters the market to purchase government securities from bond dealers. The Fed pays for the bonds with its own IOUs, called dollars. Liquidity has thus entered the financial markets. The dealer will either buy another bond with these dollars, or deposit them in its bank. Either way, some bank ends up with more dollars at the end of the day. Unless that bank decides to hoard the cash, the dollars will find their way into the interbank market. Hence, the interbank rate, known in the U.S. as the federal funds rate, declines. In short, purchases of bonds by a central bank add liquidity—dollars, in the case of the Fed—to the financial system.6 Indeed, this would result from any asset purchase (including the making of a loan) by the central bank. The bank’s balance sheet is expanded: bonds or loans on the asset side; dollars, or whatever the country’s currency is, on the liability side.

The intention of the Fed with its liquidity injection as narrated above was to lower interest rates, hence borrowing costs, for households and businesses, thereby inducing them to increase expenditures, hence GDP. Lower interbank rates, by themselves, don’t do the trick. The Fed hopes that the decline in the federal funds rate will filter through the financial markets, ultimately causing longer-term interest rates—upon which borrowing and spending decisions are based—to drop as well. How so? The lower federal funds rate prods banks to be less aggressive in issuing deposits, such as certificates of deposits (CDs). Their rates drop, bringing down other money market interest rates which compete with CDs and other bank deposits. Investors, now searching for higher rates, extend along the yield-curve. This pushes longer-term rates lower. Furthermore, with interest rates having fallen, investors may be more willing to accept credit risk as they seek to replace yield in their portfolios. Risk spreads on corporate bonds narrow. More on these last two points—the yield-curve and corporate credit-spreads—later.

We can go through the reverse scenario quickly. Suppose the economy has been growing above its potential rate, so that the central bank fears inflation. To clamp down on aggregate demand the Fed wants interest rates to rise. It sells assets from its portfolio. The financial system is left with less cash, or liquidity, causing the interbank rate to be bid up. In turn, and subject to the caveats to be discussed below, money market and then long-term rates rise, dampening spending by those sectors sensitive to interest rates.7

It is important to note that the federal funds rate can rise or fall without any action on the part of the Fed. Indeed, this happens because of inaction on the part of the Fed. Suppose GDP rises. A greater level of economic activity requires more liquidity. If the central bank is not forthcoming with the additional liquidity via asset purchases, some banks will be searching for it in the interbank market. The federal funds rate will rise, with the ensuing repercussions as described above. If the Fed does supply the necessary dollars, it is said to have “validated” the demand for liquidity. How does the increase in the federal funds rate restore equilibrium if the Fed decides not to validate (perhaps because the economy is deemed strong enough)? Some banks may be sitting on excess liquidity, or reserves, which they may decide to lend now that the return on lending has risen. Or, some banks may approach the Fed for a loan, which is equivalent to the Fed purchasing additional assets.

IMPORTANT CONSIDERATIONS

While correct as far as it goes, this analysis is too simplistic, and corporate bond investors need to understand why. The key is the yield-curve, the relationship among interest rates over different maturities. The central bank’s monopoly over liquidity creation allows it to set overnight rates, but what about rates for longer maturities (which influence aggregate demand)? As we will elaborate upon shortly, expectations about future interest rates, in turn driven by the business cycle, inflation outlook, savings rates, and government deficits, determine longer-term rates relative to shorter-term rates. And these fundamental factors are in large part outside the realm of the Fed.

Wait a second! If the Fed can control short-term interest rates, and longer-term interest rates reflect expectations of these very same short-term rates controlled by the Fed, then the Fed is responsible for all rates—either directly through their actions or via expectations of such! On the surface it does seem so. Further inspection shows otherwise.

The crucial point to recognize is that interest rates have been around a lot longer than central banks. Clearly, therefore, central banks cannot be the sole determinant of interest rates. Rather, at any point in time there is an “equilibrium” rate of interest for any given maturity. This rate reflects the confluence of fundamental factors, all finding expression in the supply of and demand for credit (as opposed to liquidity). Savers—mostly households—supply credit. Firms and governments (unless budgets are in surplus) demand credit. The equilibrium interest rate clears supply and demand. On top of this “real” rate is added a premium for expected inflation for that particular maturity. Where does the central bank fit into this framework? Through its monopoly on liquidity creation, the central bank, in the manner described earlier, can force the actual interest rate to diverge from the equilibrium rate. Indeed, this is what central bank monetary policy is all about. When the economy is weak (in our framework, a wide GDP gap) the equilibrium interest rate will fall on its own. Households tend to save a greater portion of their income in bad economic times, and firms have less of an incentive to borrow for capital expenditures.8 The now lower interest rates should, theoretically, induce households and businesses to spend more. Practically, though, they may not (in reaction to the macro-economic weakness). And even if they do, it may happen too slowly to satisfy the central bank. In that case, the central bank will add liquidity to push short-term interest rates below their equilibrium levels, hopefully forcing long-term rates down as well, in order to spur aggregate demand. Conversely, a strong economy (a narrow, even negative, GDP gap) raises the equilibrium real interest rate, reflecting reduced households savings rates and healthy demand for capital by firms. The central bank may fear an inflationary outcome if the situation is permitted to proceed on its own. It will then remove liquidity in order to raise short-term rates above the equilibrium rate, hoping long-term rates will follow, which will discourage spending and cool off the economy.

So, what’s wrong with this version of the macro-economic story? Can we not conclude that the central bank “fine-tunes” interest rates in order to achieve macroeconomic stability? It’s wrong because it suggests that the central bank has complete control—not over the economy, of course, but over interest rates. It doesn’t. Suppose the bank holds rates too low, that is, compared with the equilibrium rate that would otherwise equate supply and demand for credit. The bank must continually pump liquidity into the financial system. The result is inflation.9 At worst it occurs very soon, at best it becomes expected and built into financial contracts. In any case, the currency loses its value. In the extreme, people refuse to hold it, which erases the central bank’s power entirely, as it resides in its monopoly over a commodity that nobody wants. Conversely, should the bank keep interest rates above the equilibrium rate for too long a period, individuals and institutions will adapt. With the cost of liquidity high, they will economize on cash and develop means of transacting that bypass the now expensive central bank liability. Again, the bank’s capabilities are compromised.10 In short, the central bank can only force interest rates away from their equilibrium values temporarily.

But how long is temporary? No one knows, not even the central bank. What we can say for sure is that the longer interest rates are maintained away from their equilibrium values, and the further the distance, the greater the probability of the currency losing its status as the ultimate source of liquidity, and with it the central bank’s monopoly over liquidity. Central bankers understand this.

What does this imply for corporate bonds? A lot. Along with sector (e.g., government vs. corporate bonds) choice and issuer selection, investors must make a maturity decision. This involves, among other parameters, expectations about where interest rates (and credit-spreads) will be in the future. Building these expectations, we can now conclude, involves analyzing the likely course of the economy and attendant supply and demand for credit (more than liquidity). Such an analysis follows.

THE YIELD CURVE

With this fundamental background in mind, let’s think about the yield-curve and, crucially for corporate bonds, the spread curve. The yield-curve represents the relationship, at any particular point in time, between yields on bonds and their remaining maturities. Yield-curves are typically presented for benchmark government bonds, so that the curve reflects “pure” interest rate factors and is not confused with credit risk, liquidity, and other factors.11 Fundamentally, the shape of the yield-curve is determined by:

• Expectations on the part of market participants as to future (short-term) interest rates

• Expectations as to inflation over the period covered by the bond

• Interactions between supply and demand factors pertaining to particular points (maturities) on the curve plus risk aversion

• Interest rate volatility and bond convexity12

The first two factors can be said to be primary, as they explain, in a quantitative sense, the bulk of the yield-curve; the last two factors are secondary. The state of the macro-economy, its point of cyclicality, and expectations thereof, find expression in the primary factors. This is where the above analysis will suit us perfectly. So, let’s examine the stylized yield-curve contained in Exhibit 5–1. It is upward sloping, a curve shape typical of an economy in the early days of economic expansion. The “yield” column contains long-term interest rates, the focus of yield-curves. Each yield equals the average of the “forward” rates up until that year, contained in the second column.13 Forward rates may be thought of as market participants’ expectations for the one-year interest rates to obtain during that future year. Bond yields are “nominal,” in that they equal the sum of the real interest rate and the market’s view of inflation over the term of the bond. Hence, the next two columns present these ingredients for each future year. Each pair represents the market’s expectation for the real interest rate and inflation rate, respectively, for that particular year, and sum to the forward rate for that year.14

EXHIBIT 5–1
Components of Corporate Bond Yields for 10-Year Yield-Curve

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Let’s examine the entries of Exhibit 5–1, and the resultant yield-curve, in the context of macro-economic dynamics. Keep in mind that the interest rates in the columns under discussion thus far are for Treasury securities, i.e., they are (default) risk-free rates. The exhibit paints a stylized picture of a weak economy, but one expected to begin its rebound within a year. Consider the (nominal) forward rate column, which equals the sum of the next two columns, as just stated. In the current year (year 1), with economic activity restrained, labor and commodity markets have a great deal of slack, hence inflation is quite tame at 1%. The central bank has added liquidity, pushing the nominal one-year rate down to 2%. Taken together, this means that the real interest rate is 1%. The Fed’s hope is that the low rates will make borrowing and spending more attractive. Market participants, in this scenario, believe that the policy will work. When economic activity picks up next year, if expectations are borne out, liquidity demands will rise concomitantly, the central bank will be less accommodating, and short-term real rates will increase as shown in Exhibit 5–1, from 1% to 3%.

Take particular notice of the expected inflation rate column in the exhibit. Even though a pickup in the economy is expected for next year, inflation is not expected to accelerate. True, there is an empirical regularity of inflation rising and falling, more or less, together with aggregate economic activity. But it is also generally true that this relationship is lagged. That is, price pressures tend to mount only after the economy has strengthened for a while, not concurrently with the start of the strengthening. Our stylized scenario assumes that market participants expect inflation to accelerate three years from now. Thus, even though real rates are anticipated to rise only moderately then—by a half percent in year 4—as the economy continues its expansion, the higher expected inflation term interacts with the real forward rate to produce a more sizable 1% jump in the nominal forward rate.

For the subsequent few years, expectations are that both real interest rates and inflation will increase. Real interest rates will rise because the expanding economy becomes more credit demanding; inflation will increase because resources are being used more intensively, thus forcing up their prices. For year 8, market participants foresee a decline in real rates, reflecting their view of the expansion coming to an end. Yet they believe that inflation will continue to accelerate, again reflecting its lagged response to the economy’s dynamics. This prevents the forward rate from declining. It is not until year 10 that inflation, with a couple of years of economic weakness behind it, is expected to turn. The forward rate then falls. The yield-curve’s shape, though, remains upward sloping throughout.15

THE SPREAD CURVE

The sixth column contains the credit-spread for the relevant future year. Credit-spreads are the investor’s compensation for risk of default, hence are added to the risk-free government bond rate to produce corporate bond yields.16 The greater the risk of default, the wider the spread. Which corporate bonds? As this is a stylized analysis, we’ll assume it refers to an average of various grade credits for each maturity. When analyzing credit-spreads over maturities, two factors come into play.

1. Cyclical nature of corporate profits. As explained at the outset, expanding economic activity is usually associated with increasing corporate profits, and narrowing spreads. The expectations set underlying the yield-curve in Exhibit 5–1 is one of a rebounding and then accelerating economy. Hence, along with expectations of rising risk-free interest rates, due to increasing credit demand, come expectations of narrowing corporate credit-spreads, reflecting ever greater ability of firms to service their debt. With inflation expected to gather steam in later years, however, the worry is that wages and material costs start to accelerate, perhaps faster than output prices, hurting corporate profitability and widening spreads for further-out years.

2. Time factor in credit risk. All else the same, the longer the maturity of a corporate bond, the greater the likelihood of default. Why? The longer the time frame, the more chances of negative events occurring, which reduce profits and, as the events compound, lead to default. True, the chances of positive events increase as well. But remember, bondholders do not gain from positive shocks to corporate earnings (as equity owners do). They stand only to lose from negative events. Hence, the longer the maturity, the greater the default risk, and the wider the credit-spread.

In short, during expansionary periods, or expectations of such, these two factors are typically counteractive elements in the corporate yield-spread curve—adding years to the (noninflationary) expansion narrows credit-spreads, while lengthening maturities widens them. The corporate yield-curve presented in Exhibit 5–1 assumes the cyclical factor dominates in the near years. For later years, the combination of the time factor plus expectations of wage and materials price inflation does the reverse. If, instead, the economy were in the throes of a contraction, the factors would typically be re-enforcing. Corporate credit-spreads would widen substantially with maturity, even for the early years. Indeed, a result is that in some situations the government bond yield-curve may be downward sloping, reflective of overall macro-economic weakness and expectations of such, yet the corporate curve slopes upward.

CYCLICALITY OF CREDIT SPREADS

In the previous section we examined a stylized picture of yields and credit-spreads over a range of maturities for a particular point in time (i.e., a corporate bond yield-curve). Here we’ll look at how corporate yields and spreads tend to behave dynamically over the business cycle. We consider both high-grade and high-yield corporates.

The discussion revolves around the information in Exhibit 5–2, which contains long-term, stylized averages of bond yields. The first column describes the state of macro-economic activity relative to the country’s potential, as explained above. Let’s begin with Treasuries, the yields of which anchor the rest. Recall that government bond interest rates, lacking a credit risk factor, contain only two components: a base interest rate, known as the real rate, plus a premium for the inflation rate expected over the life of the bond. The line labeled “potential” in Exhibit 5–2 refers to an economy operating with a GDP gap just above zero, a sort of neutral situation. In such an environment, we can assume a ballpark average real rate of 3%. A midpoint 3% rate for inflation is reasonable as well, since we need to look at time periods longer than just recent experience. Hence, the Treasury (nominal) yield is 6%.17 The “weak” line denotes the economy operating substantially below its potential. This is not necessarily a recession (a contracting economy), but recessionary periods are included in the average here. Real interest rates are lower in this stage of the business cycle, reflecting both weak credit demand and ample liquidity supplied by the central bank. Inflation tends to be more volatile than real interest rates. Hence this entry assumes a real rate of 2% and inflation of 1%, or a Treasury yield of 3%. Conversely, the economy operating above potential—the line labeled “strong”—results in higher inflation, say 5%. Credit demand is more robust, which, together with the Federal Reserve holding back on liquidity growth to prevent further inflation, pushes the real rate up to 4%, for a total of 9%. We’ll get to the last line later.

EXHIBIT 5–2
Yields over Various Stages of the Business Cycle

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The entries in the investment grade corporate bond column equal the Treasury yield (real interest rate plus inflation) plus a spread for credit risk. That spread, in turn, reflects a host of fundamental factors including the makeup of the firm’s balance sheet, characteristics of the particular industry, company and management history, and from the investors’ side, their degree of risk aversion. In terms of our macro-economic focus, most important is the firm’s expected earnings. Each individual firm’s sensitivity to the stage of the business cycle is unique. However, considering the high-grade sector overall, corporate profits, as we saw above, are certainly positively related to macro-economic activity. Let’s begin with the middle line again. A midrange figure for credit-spreads, associated with the economy operating near its potential, is 1.5%, hence the 7.5% entry. Weak economic activity reduces average corporate profits, raising default risk and with it default spreads, from 1.5% to 2.5%, producing the 5.5% figure. At the other end, with macro-economic activity above the country’s potential, spreads tighten to 1%, reflecting outsized corporate profits, which adds up to 10%. Credit-spreads, in other words, are counter-cyclical—they contract during an economic expansion, and expand during an economic contraction. This is a very important conclusion because, as explained just above, Treasury interest rates are pro-cyclical. Thus, the two components of corporate bond yields—Treasury rates and credit-spreads—offset each other over the course of the business cycle. Another way to say this is that corporate bond yields exhibit less volatility—on an absolute or a relative basis—than Treasury yields, as is clear from the first three lines of the table. Nevertheless, their correlation is positive. Notice further that weaker than average corporate earnings add a full percent to average credit-spreads (compared to the potential line), whereas stronger than average earnings subtracts only half a percent. Why the lack of symmetry? Simple: the most spreads can fall to is zero, while upside is limited only by actual default. To summarize:

• The yields on high-grade corporate and government bonds exhibit positive correlation over stages of the business cycle.

• High-grade corporate bond yields are less volatile than their Treasury counterparts.

Turn now to the final column. Credit-spreads for high-yield bonds preserve the cyclical pattern found in the high-grade column—widening during recessions, tightening in expansions. But the degree of cyclical sensitivity is so high for the speculative bond sector that it perverts the overall relationship with Treasuries. Consider: the “high-yield” in speculative grade bonds is due, of course, to their very wide credit-spreads over credit-riskless government bonds. The wide spreads, in turn, reflect substantial risk of default, largely the result of greater leverage in the firms’ balance sheets and, compared to the high-grade sector, more volatile industries (e.g., manufacturing as opposed to utilities). The sector’s earnings, therefore, are acutely susceptible to movements in aggregate demand in the macroeconomy. The effect of this earnings cyclicality on credit-spreads is augmented by the dynamics of investors’ risk appetites. Risk aversion tends to decrease during expansions, increase in recessions, reflecting the natural correlation between income/wealth and willingness to take risk. Together, these factors tend to make spreads on high-yield bonds sharply sensitive to the business cycle. This combination of high-yield and greater sensitivity to the business cycle has two major implications for investment portfolios. Compare high-yield spreads (column 4 less column 2) with high-grade spreads (column 3 less column 2). The former exhibits much greater volatility. Here lies the perverse relationship. Both spreads are counter-cyclical, as is clear from Exhibit 5–2. But the proportion of a high-yield bond’s interest rate due to the credit-spread component is of an order of magnitude greater than it is for high-grade interest rates. For example, in line 2, the highgrade spread accounts for one fifth (1.5/7.5) of the total rate, whereas the high-yield spread accounts for nearly one half (5/11). Hence, any movement in Treasury rates over the business cycle is swamped by movements in the high-yield spread. This negates the correlation between Treasury bond and high-yield bond interest rates. We can conclude:

• Not only do speculative grade bonds present higher yields than investment grade, their credit-spreads are more volatile over the economy’s business cycle.18

• Whereas investment grade bond yields exhibit positive correlation with those of Treasury bonds, the larger role of credit-spreads in speculative grade bonds erases any meaningful correlation with Treasury yields.19

STAGFLATION

There have been few episodes of stagflation in the modern U.S. economy, but they are not forgotten. Stagflation denotes a period of macro-economic stagnation accompanied by inflation. Stagnation describes an economy operating well below its potential, hence with substantial unemployment. It does not necessarily qualify as a recession, as economic activity is not contracting further, though it may likely follow a period of contraction. Yet, despite the macro-economic weakness, inflation is relatively high. A situation of stagflation can be the result of a period of rising commodity (typically oil) prices, and/or inflation expectations which have become embedded in the economy. Stagflation is devastating for corporate bonds.20 Profits are down, due to weak economic activity. Firms are not adding to their capacity, as inflation creates uncertainty regarding future product demand. This combination of inflation, uncertainty, and economic lethargy causes risk premiums on corporate debt to widen dramatically, as shown in the last line of Exhibit 5–2. A sharp eye will notice the qualitative difference between the stagflation line and the others in the exhibit. Using the potential line as the benchmark, observe, as we have before, that in both the weak and strong periods, the Treasury rate and the risk premia (for both high-grade and high-yield corporate) move in opposite directions. The dynamics are starkly different under a regime of stagflation. Treasury rates increase, due to their inflation component. Yet, at the same time, spreads widen considerably. In short, credit-spread widening exacerbates corporate yield increases during periods of stagflation.

CORRELATION AND CAPITAL STRUCTURE

Our final topic relates not to the impact of macro-economic shifts on corporate bonds as a whole (or on corporate bond sectors). Rather, we examine the differential effects of macro dynamics on corporate bonds situated at different points on the issuer’s capital structure. Some bonds are secured by collateral (effectively making them more senior in the firm’s capital structure), while others are uncollateralized (known as debentures, hence are subordinated, or junior). The role of collateral in reducing the credit risk of corporate bonds is intimately wrapped up with the concept of correlation. This is not a well understood concept. But it is crucial in correctly analyzing the relative values of collateralized vs. uncollateralized bonds, particularly in a macroeconomic context.21

Suppose a retail chain has issued bonds, half of them senior, half subordinated. The company owns a major building within which lies its flagship store. The building serves as collateral for the senior debt, hence that debt is secured. In the event of default, the keys to the building are handed over to the bondholders. The junior, or subordinated, debt is uncollateralized.22 Exhibit 5–3 examines the four possible scenarios facing the firm, and their implications for the two classes of bondholders.

EXHIBIT 5–3
Possible Scenarios for Retail Chain Bond Issuer (√:survival; ×:default)

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A“√” mark denotes survival of the particular entity or asset (at least until the bonds mature); an “×” represents lack of survival. Clearly, the four scenarios exhaust all possibilities. We will make the simple assumption that the functioning retail business on its own can pay off both classes of bondholders, and the real estate, if necessary, can be sold to pay off the senior debt. For our purposes no probabilities need be associated with the possible outcomes. Still, from a macroeconomic perspective, Scenario I is the most likely. If the firm’s retail business survives, both the senior and junior debt will be paid in full. The fact that the building has retained its value is certainly a good thing for the firm, but in this situation presents no additional benefit to any of the bondholders.

If the firm’s core retail business falters, and the firm defaults on its debt, the senior secured debt holders will look to the collateral (assuming the firm’s other assets have already been deployed to pay off other creditors standing in line before bondholders, such as the government looking to collect any back taxes) for repayment. In Scenario II, the building has held up, so the senior debt is paid in full, which was the point of the collateral in the first place. The subordinated claimants go home empty handed (the building’s market value is only enough to pay of the senior debt).

Scenario III represents the reverse, and less common, situation—the firm’s business is doing fine, at least enough to cover its obligations to both bondholders, but the building has lost value. The decline in real estate, in this case, is effectively irrelevant to the bond positions.

Finally, Scenario IV has the retail business failing and the real estate depreciating to the point where the senior debt holders cannot be repaid in full. Not very likely, but quite possible (the recent recession serving as a dramatic example).

Let’s step back and take a closer look at the senior, secured bondholders’ position. They will only lose under Scenario IV, as they draw their payment from either the retail business or the real estate. Looked at another way, they will only lose if both businesses, or assets, fail to cover their claim. Now think about an extreme case. What if the real estate and retail business are perfectly negatively correlated? In that case Scenario IV could never unfold. The senior debt holders could never lose! Said differently, their only possibility of loss reflects the extent that the building and the firm’s business show any degree of positive correlation, making Scenario IV at least possible. Indeed, the more highly correlated, the more risky their position, as this would increase the chances of Scenario IV unfolding.23

Before we consider the other theoretical extreme—the retail business and the real estate are perfectly positively correlated—let’s look at risk from the subordinated bondholders’ perspective. If the company defaults, due to the retail business’s deterioration, the junior bondholders will not be looking to the real estate for payment; the building secures the senior debt holders, and that’s it. Both scenarios II and IV are what these lenders worry about. In other words, the second column in Exhibit 5–3 is irrelevant to them. If the two businesses are perfectly negatively correlated, they still lose in Scenario II; in contrast to the senior, the junior bond holders do not benefit from the negative correlation.24

Now consider the opposite extreme—the firm’s retail selling business is perfectly positively correlated with the value of the building serving as collateral. In this case, only Scenarios I and IV can occur. In I, both classes of bondholders are paid; in IV, neither. Under perfectly positive correlation, therefore, there is no added benefit to being senior/secured. Another way to say the same thing is, the more positively correlated the collateral is to the core business of the bond issuer, the less valuable the collateral as an enhancement to being senior in the company’s capital structure. And the less valuable, the less it should cost to be senior; that is, the less they should give up in yield. In bond terminology, the greater the correlation, the narrower the difference in interest rates, or spread, between the senior and junior debt holders.

Here, then, is the straightforward macro-economic implication. Business cycles are characterized by their breadth as well as depth. A downturn can be quite severe, but it may bypass some sectors of the economy. Real estate, for example, may hold up as aggregate demand falters, i.e., it exhibits weak correlation with the rest of the economy. In that case, collateralization is useful, and secured bonds are not as negatively impacted (their credit-spreads widen modestly). The 2008–2009 downturn was different. It was not only sharp, but broad. Indeed, real estate suffered relatively more than the economy as a whole. Collateralization proved less beneficial, which was reflected in dramatic corporate bond spread widening across all classes.25

KEY POINTS

• The ability of firms to service their debt is, in the aggregate, dependent upon the level of macro-economic activity. Generally, higher GDP levels are associated with greater income and profits. Conversely, recessionary GDP levels reduce the ability of firms to service debt, hence increase the risk of default. Understanding the drivers of the economy, therefore, are crucial to investing in corporate bonds.

• Corporate bond yields are the sum of the Treasury rate plus a default risk premium. In turn, the former includes a real interest rate and a premium for expected inflation. The Treasury yield-curve reflects, fundamentally, investors’ expectations regarding the course of the business cycle and its interactions with inflation. Inflation in the short run is a function of the GDP “gap;” in the long run it is a monetary phenomenon. The monetary authority can “control” short-term (interbank) rates through its near monopoly on liquidity creation, but in the long run it cannot deviate significantly from the economy’s equilibrium interest rate.

• Spreads on corporate debt are determined by overall economic dynamics, sector sensitivity to the business cycle and firm-specific factors such as leverage. Investor risk appetites play an important role as well, especially in the high-yield sector. The “spread curve” reflects two, sometimes competing, factors. The longer the maturity, the greater the chance of a negative event. At the beginning of a macro-economic rebound, the longer the time frame, the greater the chance of the economy, hence companies, gaining earnings momentum.

• High-grade corporate bond yields are less volatile than Treasury yields over a complete business cycle because credit-spreads are counter-cyclical, whereas the risk-free rate tends to be cyclical. Still, investment grade bond yields show positive correlation with Treasury rates. High-yield bonds may show greater volatility, depending on the sharpness of the cycle, and by nature present little correlation with Treasuries.

• Corporate bonds of the same issuer can react differently to macro-economic dynamics, depending on their positions in the firm’s capital structure. Senior bonds, particularly those secured with real estate, are hurt only if both the firm’s business (producing the cash-flow) and the collateral are insufficient to pay off the debt. Hence, the more negatively correlated the two, the less risk faced by the senior debt holders (and the narrower their required credit-spread). Subordinated, uncollateralized bond holders gain little from negative correlation, as they do not look to the collateral for payment.

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