The End Is Near for the US Credit Cycle. Are You Prepared?

The US corporate credit cycle is nearing its end, and the cycle in parts of Europe isn’t far behind. This can create treacherous conditions for unprepared investors. The first line of defense, in our view, is knowing what to expect.

Credit cycles have distinct stages. During the expansionary period, easy access to credit helps boost earnings and prompts companies to take on debt. As debt levels rise, so does credit risk. Asset values start to decline. That raises default risk and causes lenders to get stingier. A rise in interest rates then leads to contraction and balance-sheet repair and, eventually, a recovery phase (Display).

The current US credit cycle began with the recovery that followed the global financial crisis and has nearly come full circle. The Federal Reserve is actively trying to tighten financial conditions and will likely raise interest rates several more times this year to counter inflation. And many US assets, including leveraged bank loans and many high-yield and investment-grade corporate bonds, are again nearing the contraction stage of the cycle.

The European Central Bank is a few steps behind the Fed. But it, too, is slowly winding down its easy monetary policy as the economy gains traction, and is expected to begin hiking rates in early 2019. That situation could eventually affect European industrial issuers, who today are adding leverage.

No one knows exactly when a credit cycle will end. In the US, new rules allowing companies to repatriate overseas profits at a lower tax rate could even extend the current cycle. But it’s clear that we’re closer to the end than the beginning.