Fixed income investors have experienced an era of extremely low interest rates over the past decade. It is expected that central banks will continue to raise interest rates in order to curb prolonged inflation. In this new environment, corporate bonds can play a useful role in portfolios because different types of credit can be used at different stages of the economic cycle.
The four stages of the economic cycle
expansion
During periods of expansion, output increases and the economy grows rapidly. Growth is good for business. Companies are less likely to default on their debts because revenues tend to increase and balance sheets improve. Interest rates tend to be low. However, towards the end of the expansion cycle, the increase in the money supply causes inflation to accelerate. As production increases, so does the demand for raw materials, manufacturing materials, and energy sources. Commodities, gold and cash tend to perform well, and short-term credit typically plays a larger role in the portfolio at the end of the expansion phase.
Economic slowdown/stagflation
Once growth peaks, the economy begins to slow down. Inflation will continue to rise and businesses will begin to tighten their belts. Growth momentum is turning negative, business conditions are deteriorating, profits are declining, and more companies are defaulting on their debts. Government bonds and investment grade bonds have fared well in this environment.
recession/disinflation
From here, the economy typically slides into disinflation. During this period, growth continues to slow, eventually tipping into negative territory. Employment will fall, prices will stagnate, and default rates will bottom out. The measures taken by central banks to control inflation are starting to take effect and inflation should fall. Investment-grade companies typically survive recessions well, and toward the end of a recession, high-yield opportunities begin to increase as growth resumes with positive momentum.
recovery
Once inflation slows and returns to target, central banks begin to ease monetary policy and interest rates fall. High-yield bonds are sensitive to economic conditions, so they typically continue to perform well during this stabilization phase.
conclusion
Overall, there are winners and losers in any market environment, highlighting the importance of a proactive approach to investing. Not all markets are at the same stage of the economic cycle at the same time. Our proactive approach gives investors the flexibility to invest across sectors and geographies throughout the cycle, pursuing the best opportunities.
