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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.

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.