High Yield Credit Follow-Up

If you are too busy to read my recent post on Marty Fridson’s speech at the Grant’s conference…


…the following chart by JP Morgan sums it up nicely:


The chart shows how the volume of high-yield issuance leads default rates, the more bonds are issued over a cycle the higher the proportion of failing companies in the future. This chart suggests that high issuance activity leads to lower credit standards and hence higher default risk. Now, we all know that correlation is not causation but I do not think that the pattern observed is spurious. If you subscribe to this logic you should als demand higher credit risk premia as issuance volume rises. Now, in reality markets behave in the opposite way: high issuance tends to correlate with low spreads and vice versa? How can this be?

My professor at university was a “Journal of Finance”- type of guy and a firm believer in efficient markets – a respected figure in academia. I remember a discussion with him on credit cycles, such as depicted on the chart, where he was surprised by the fact that credit cycles exist, after all, the rational agent in the standard theoretical models is supposed to “look-through” all this correctly on average and take all facts (such as this chart for example) into account. Standard theory cannot explain credit cycles and conveniently assumes it is a spurious phenomenon, i.e. it doesn’t really exist. Just like bubbles do not exist. My Professor has taught me a lot and I am still grateful for the excellent education I got, but I certainly do not agree with him on this. As a consequence of our conversation and being a practical investor with a theoretical bent I thought a lot about this problem over the years.

From an Austrian perspective the mainstream view is flawed as it treats the price (i.e. the risk premia) as the result of people’s actions: the rational agent optimizes his portfolio given his preferences and the correct economic model (think distributions, risk factors a.s.o). This optimization exercise yields the market efficient price, i.e. currently record low total yields on junk debt accurately reflect likely defaults in the future. In other words: the correlation observed in the chart is entirely spurious, it is a coincidence.

According to the Austrian worldview the world is too complex for anyone to understand it (i.e. the agents either cannot know “The model” or there is none), consequently it doesn’t make sense to model them as if they optimized some model. Rather, they base their decision on prices: observed and expected prices are the BASIS of their actions – NOT the result. It was the Austrian economists who first stressed the information aspect of price.  Without true market prices, a society based on the division of labour cannot exist and, taken to the extreme, is bound to collapse. This insight allowed Mises already in 1922 in his book “Die Gemeinwirtschaft” (“Socialism” in english) to predict the failure of communism/socialism at a time when western intellectuals were exited about the “communist experiment” unfolding in Russia. Hayek took the analysis even further and ultimately received the economics Nobel Price for his work. (Not that I think much about economics Nobel winners)

As an Austrian, therefore I am not surprised to see anomalous behaviour whenever I know that non-market (i.e. central bank determined interest rates) prices influence the decisions of market participants. In product markets manipulated prices are accompanied by such phenomena as under/overproduction of goods/services. The famous queues in front of bakeries under communism come to mind. The ill effects are not limited to “real”‘ products, however: Far from it. Austrian business Cycle Theory shows that manipulated interest rates are the main driver behind boom and bust, recessions and depressions.

Consequently I DO expect the chart above to be a meaningful predictor of what is likely ahead.  Nobody, of course can predict with any scientific precision when and how the events are going to unfold. Managing these choppy waters successfully as an investor is probably better classified as art rather than science.






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