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The sensitivity of corporate bonds to the economic environment essentially depends on their time to maturity. In the short term, default risk for investment grade corporate issuers is primarily due to nonsystematic factors, for example, cases of fraud or litigation. Over longer term horizons, conversely, systematic factors tend to have a higher impact on the default probability of corporate issuers. Changes in the economic environment and business risks in the sense of adverse industry trends or increasing competition are major drivers of credit risk and hence for spreads in the longer term. Therefore, one would expect the spreads of long and intermediate investment grade corporate bonds to be more sensitive to indicators of economic activity than short-term bonds. This implies that credit curves should flatten when the economic outlook improves. Rising confidence in the corporate sector additionally spurs investors’ willingness to take on more spread duration. Consequently, in periods of spread tightening investors should expect credit curves to flatten. In other words, the slope of the credit curve and the level of credit spreads are positively correlated for investment grade issuers.

The steepness of the yield curve follows a certain pattern over the business cycle. The 1991–2001 economic cycle is representative for past economic cycles in the sense that it displays the usual pattern for the correlation between yield curve steepness and industrial production. But it is special because it comprises the longest economic expansion in the United States since the NBER started dating recessions back in the 1850s.

The management of the yield curve is a central element of fixed income portfolio management, even for corporate bond investors. However, many of them tend to take no or rather small active exposures with respect to duration and the positioning on the yield curve. Consequently, active positions with regard to sector and issuer exposures are responsible for a large part of the out- or underperformance versus the benchmark index.

Since corporate bonds as an asset class clearly depend on the boom and bust of the economy, it seems natural that not only the spread level but also the slope of the credit curve may – similar to the slope of the yield curve – be related to economic activity. The question then is if taking active positions on the credit curve can attribute to the performance of a corporate bond portfolio.

Many government bond investors believe that deviations of treasury yield curve steepness from the traditional range or a fair value obtained by regression analysis are only temporary. That is, they expect yield curve steepness to be mean reverting. From a theoretical point of view there is strong support for this hypothesis. In the early stages of the business cycle, that is at the beginning of an expansion, monetary policy is easy and shortterm interest rates are still low. But an improving outlook for future economic growth leads to rising long-term interest rates and a steeper yield curve. The later stages of the expansion are characterized by rising inflationary pressures and consequently central bank tightening. The most  impressive example for this experience were the seven interest rate hikes by the Fed between January 1994 and January 1995, that led to a sell-off in the treasury market and were accompanied by a massive flattening of the yield curve. When the tighter monetary policy begins to unfold its influence on price growth, this is usually followed by weakening economic growth. In this economic environment yield curves steepen again, because short-term interest rates tend to price in room for central banks to cut interest rates.

Spread volatility is one of the most important underlying drivers of nominal spreads. Investing in more volatile sectors requires a higher compensation (higher option adjusted spread) because it is more difficult to target projected returns. There is a close relationship between aggregate spread levels and aggregate spread volatility. Periods of tight spreads are accompanied by lower spread volatility. When spreads tend to widen the spread volatility will also increase.

Sector betas are used as a measure of risk and signal the systematic risk of a sector. Corporate bond betas are computed on the basis of spreads and are, like the equity betas, useful indicators for the assessment of the different risk profiles of various companies and sectors. A high beta indicates an above average investment risk, because it depends on the average leverage level of issuers from a sector. The change in betas over time reflects the change in relative risk of a sector versus the overall market.

It can be stated that senior banks were less volatile than the telecommunications and automobile sectors. Especially the automobile sector and subordinated insurance increase the risk profile of a portfolio due to higher volatility and offer more potential to outperform/underperform the corporate benchmark if an overweighting is targeted. Services noncyclical and technology appear unattractive as they offer a relative low spread and a high spread volatility. The media, telecom and services cyclical sectors have an attractive risk-return profile and consequently should be overweight in a portfolio. The different spread volatilities of the sectors lead to divergent investor behavior regarding risk aversion /appetite, which in return results in different risk premia (spreads).

The rating differences between the various sectors have to be considered as well because in this example we compare AA-rated financials with low A/high BBB-rated telecommunication and automobile companies.

Sector fundamentals have to be put in perspective to valuation. The relative value approach is a common method for sector rotation strategies. It supplements the fundamental analysis of the sectors and improves the decision to overweight or underweight specific sectors. In a first step the aggregate spread levels of sector indices are compared with their respective spread volatilities. Typically the spread volatilities (annualised standard deviation of daily spread changes) will increase with an increasing spread level of the different sectors. This procedure allows to identify sectors whose risk-return profile relative to the whole market is attractive (overweight) or unattractive (underweight). This approach can also be applied on the company level but a lesser weight should be assigned to the results for lower rated credits which require an in-depth credit analysis in the first place.

Technical factors have to be considered in the decision process regarding the weighting of various sectors in a corporate bond portfolio. First of all, projections about the expected net new issuance volume have to be made. All redemptions in an industry are known and the projected financing needs of all companies within an industry add to the total expected issuance from a specific sector. In the past, the largest issuance volume has been concentrated in the automobile, telecommunications and utility sectors.

It has to be evaluated whether the new issuance volume can be absorbed by the market or whether it will put pressure on spreads. The general risk appetite/aversion of market participants and the prevailing sentiment towards the various sectors will give a hint about the demand for certain sectors. Another important factor is liquidity because it will vary substantially between sectors. Furthermore if investors want to express a certain view on different maturity buckets within a portfolio the choice might be limited to a few frequent borrowers who have bonds in all maturity buckets outstanding. Those companies are usually concentrated in the automobile, telecommunications and utility sectors.

Amajor reason why sectors experience significant shifts in their average ratings is the degree of cyclicality. Noncyclical sectors usually have a stable credit trend whereas cyclical sectors are heavily dependent on economic cycles and their rating outlooks move in tandem with the economy even though it has to be pointed out that the rating agencies try to rate through the economic cycle, meaning that cyclical swings should be incorporated in a company’s rating. Macroeconomic dynamics can drive the negative credit trend of industries and single companies, affecting their credit spreads even more than company-specific problems and risks. At this stage we want to point out that external shocks, which endanger geopolitical stability, can bring the whole economic system in disorder. After the tragic events of 11 September 2001 the airline and leisure industries were hit the hardest and a spread widening of 360 and 185 bps respectively was recorded. An average widening of 30–40 bps across all other sectors occurred in the short term, whereas the cyclical industries like automobiles showed higher spread movements than noncyclicals.

The rating outlook of both rating agencies (S&P and Moody’s) can be another criterion to choose between industries. If companies with a positive rating outlook outweigh the companies with a stable or negative rating outlook within an industry, it can be a good indicator for favorable industry dynamics, even if we have to recognize that ratings are sometimes lagging indicators for credit quality. A diversified portfolio should overweight the industries with a positive rating outlook and underweight industries with a negative rating outlook if the whole credit market experiences a “Flight-to-Quality.” During a market phase with a higher risk appetite, fundamental factors like the rating trend in a specific industry might not be the primary decision criterion for a sector positioning and other factors like valuation
will play a bigger role.

The occurrence of event risks is almost unpredictable hence they are hard to quantify. Most of the event risks can be associated with the creation of shareholder value. This can be share buyback programs, an aggressive acquisition strategy, or isolated, risky projects which change the capital structure of a company in favor of shareholders. A wealth transfer takes place from bondholders to shareholders of a company. This kind of event risk can be reduced by regular meetings with management. Unfortunately many event risks are out of control for management and sometimes the effects are not isolated for a specific company but have an effect on the entire industry. In the past good examples can be found for various industries.

Many capital goods companies are facing asbestos claims which weigh heavily on their financial profiles. Especially in a market phase with increased risk aversion these topics are brought up and heighten the negative sentiment of market participants against sectors with increased asbestos liabilities. The telecommunications sector faces new challenges through wireless technologies. European state regulators set license fees for wireless spectrum which reached billions. This changed the financial profile of the incumbent telecommunications companies. The utilities sector goes through a liberalization process accompanied by increasingly riskier business models. The tobacco sector is always a litigation target and the healthcare and pharma sectors face a lot of regulatory risks.