How credit cycle works?
Overall, the analysis suggests that credit spreads are highly correlated with the business cycle and that there is a leverage cycle that is closely related to macroeconomic activity variables. While carry-driven strategies may work most of the time, a thorough understanding of the leverage cycle helps to anticipate a harsh credit environment, even before it is reflected in GDP growth and equity performance. As the years 1997–2000 have shown, information from the equity markets is clearly not sufficient as an indicator of business and financial risks in the corporate sector. Most companies go through a regular cycle of leveraging and deleveraging, which is related to the profit and Capex cycle. Especially trends in mergers and acquisitions have a significant impact on the performance of credit markets.
Consequently, the concept of “safe” and “risky” companies loses its allure. Companies from sectors like utilities or noncyclical services that are considered safe today may increase leverage and be more risky tomorrow. On the other hand, highly leveraged companies may decide to deleverage and thus lower their business risk, like the European telecom sector in 2002 and 2003. Although the profit cycle is more pronounced in cyclical sectors, a credit cycle may be observed across virtually all industries. Credit markets react to this dynamic process through spread tightening and spread widening, thus causing investors mark-to-market profits or losses.