Wednesday, July 27, 2011

Paper: "Issuer Quality and the Credit Cycle"

Here is a paper about credit bubbles called "Issuer Quality and the Credit Cycle" by two professors at Harvard Business School. Anyone who has been through a credit cycle can tell you that during the bubble or boom part of the cycle, the credit quality of corporate debt issuers deteriorates.

This paper argues that the "broad changes in the pricing of credit risk" that occur during a bubble "disproportionately affect the financing costs faced by low credit quality firms." As they write,

"To the extent that firms issue more debt when credit is 'cheap,' the debt issuance of low credit quality firms may then be a particularly useful barometer of financing conditions. Specifically, time-variation in debt issuer quality may be useful for forecasting corporate bond returns: following periods when debt issuers are of particularly poor credit quality credit assets should underperform."
The rest of the paper investigates the causes of time-variation in expected corporate bond returns, i.e. what causes the credit bubbles and busts? The preferred theory is naive linear extrapolation by investors that good times will keep getting better:
"Explanations that appeal investor over-extrapolation are attractive because they allow for negative expected excess returns, consistent with our findings. And, while it is difficult to measure investors’ beliefs directly, the extrapolation story predicts that issuer quality should decline following periods of low defaults or high credit returns. This pattern emerges quite strongly in the data, suggesting that the recent experience of credit market investors may play a role in shaping investors’ expectations or tastes."
As in so many human spheres of activity, people's predictions are that the future will be like now, only more so. This pattern ties into an article on the Distressed Debt Investing blog yesterday about the alarmingly exuberant conditions in the corporate credit markets:
In bearish markets, underwriters will strengthen covenant packages to attract investors to new high yield offerings when capital is scarce and precious. This is the time when investors, especially those that HAVE to play on the primary side, should be backing up the truck. This is not that time.
The two year rally in high yield corporate credit seems to have gotten everyone to forget about adversity. That means investors will be due for another lesson soon.

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