Investing across the Short-Term Debt Cycle

Credit cycles drive business cycles. 

When borrowing costs are declining, demand for goods bought on credit, from houses and cars to washing machines and televisions, increases because the monthly payments are lower relative to incomes.  In the financial economy, asset prices rise both because of the expansion in the real economy and because lower discount rates mean higher net present values.  When borrowing costs are rising, these effects are reversed. Demand slows, asset prices fall, and the economy contracts.
 
 The core challenge for investors is to invest across these credit cycles, making long-term decisions that work across multi-year cycles rather than making the classic mistake of selling in recessions and buying in expansions. 

Verdad’s strategy emphasizes the necessity of a full credit cycle approach to investing.  Leveraged small value equities are particularly sensitive to changes in the credit markets for three reasons. First, most of these small companies are more sensitive than larger companies to economic fluctuations. Second, changes in borrowing costs affect refinancing risk.  And, finally, small changes in enterprise valuations driven by changes in discount rates have an amplified impact on the equity tranche of leveraged companies.

For this week’s research update, I compare the performance of Vanguard’s full suite of mutual funds to the performance of a leveraged small value strategy, in the context of multiple short-term debt cycles, to illustrate how a strategy can work across different time periods in the short-term debt cycle.

Short-Term Debt Cycles Since 1999
We have seen four full cycles since 1999. A contraction from 1999 through late 2002, an expansion from late 2002 to mid-2007, a contraction from mid-2007 to late 2008, another expansion through 2011, a brief contraction during the European debt crisis in 2011, an expansion through mid-2014, and a contraction that lasted until February, 2016, when the next expansion began. We can see these debt cycles by looking at the widening and tightening of high-yield corporate bond spread.

Figure 1: High-Yield Corporate Bond Spreads 1999-2016

Source: FRED

Expansionary periods predominated over this time period, with borrowing costs flat or dropping 70% of the time and rising only 30% of the time. Which assets performed best in each environment and across the full cycle?

In contractionary periods, the best performing asset class was 30-year government bonds.  The worst: leveraged small value equities. Below is the ranking according to average performance in contractionary periods:

Figure 2: Returns During Contractionary Periods

Source: CapitalIQ, Portfolio123

Recall, however, that these contractionary environments only account for about 30% of total time periods sampled.  The more important question, then, is which assets perform best in the predominant expansionary periods?  The answer: leveraged small value equities by a country mile.

Figure 3: Returns During Expansionary Periods

Source: CapitalIQ, Portfolio123

Across the full-cycle, the expansionary periods more than make up for the contractionary periods, meaning that the overall ranking for absolute performance favors leveraged small value equities:

Figure 4: Returns across the Short-Term Debt Cycle

Source: CapitalIQ, Portfolio123

This research frames my approach to investing.  If you want to achieve the best possible performance in the long-term, you have to be willing to stomach significant drawdowns during periods of contraction in the short-term debt cycle.  Investors who are willing to take this risk are rewarded.  In contrast, investors who choose to put their money in assets that perform well in contractionary environments, like bonds, suffer diminished performance during expansionary periods and end up with dramatically lower long-term returns.

Figure 5: Drawdowns versus Returns

Source: CapitalIQ, Portfolio123

Conclusion
I believe that Verdad’s strategy of investing in leveraged small value equities will produce the best absolute performance of any asset class. Furthermore, I believe that it can play an important role in a larger portfolio, particularly for risk-averse investors who can use a small allocation towards our strategy to dramatically improve performance in expansionary periods relative to a low-risk bond heavy portfolio.