Anda di halaman 1dari 12

Global Multi-Asset Group (GMAG)

Investing Through the Credit Cycle

Executive Summary

Investing in credit markets can potentially offer very attractive returns over time. However,
Alessio de Longis, CFA credit also experiences transitory periods of high volatility and significant drawdowns,
Portfolio Manager which can severely impact investors portfolios.
Global Multi-Asset Group
To understand what drives the performance of credit markets, we identify three stages in
the credit cycle with the following historical patterns:

Beginning of the Cycle: Credit outperforms government bonds via significant spread
compression.
Mid-Cycle: Despite low spreads, credit offers long periods of stable returns from
income, still outperforming government bonds.
End of the Cycle: Credit experiences heightened volatility and large drawdowns,
underperforming government bonds.
If I owe you a pound, I
have a problem; but if We have developed a macro framework to anticipate turning points in credit markets,
estimating the probability of experiencing regimes of large and persistent credit
I owe you a million, the
underperformance (i.e., the end of the credit cycle).
problem is yours.
We believe this framework can help investors harvest the credit risk premium while
John Maynard Keynes
significantly reducing downside risk, therefore improving risk-adjusted performance.

Predicting the Three Stages of the Credit Cycle: Investment Implications

Stability leads to Average Annualized Excess Returns Over Government Bonds


instability. The more January 1989 December 2015

stable things become


Beginning of the Cycle Mid-Cycle End of the Cycle
and the longer things Spread Compression Stable Spreads Spread Widening
15%
are stable, the more 12.1
unstable they will be 10
Excess Return

when the crisis hits. 4.5 4.4


5
Hyman Minsky 0.4
0
2.2
5

7.5
10 Investment Grade Risk Premium High Yield Risk Premium

Sources: Bloomberg, OppenheimerFunds, Inc. 12/31/15. Investment Grade Risk Premium series is the Barclays IG Corp. Excess Return (ER)
Index. High Yield Risk Premium is the JPMorgan HY Corp. Total Return (TR) Index (backfilled with Credit Suisse HY Corp. Index prior to 2/95)
minus a duration matched U.S. Treasury TR series. See Exhibit 11 for data sources and methodology. See last page for index definitions.
Pastperformance does not guarantee future results.

Not FDIC Insured


May Lose Value
Not Bank Guaranteed
OppenheimerFunds

Investments in credit markets have historically generated very attractive returns with low volatility and stable income,
especially over long horizons. However, credit markets also experience brief regimes of heightened volatility and
sharp drawdowns, causing investors to run for the exit and reduce portfolio exposures, often too late. What causes
these sudden changes in market regimes? How is the credit cycle defined? What are its different stages and can they
be predicted?

There is no commonly accepted definition of what determines the stages in the credit cycle. Therefore, to answer
these questions we proceed in two steps:

First, we establish a reference framework and outline our definition of the theoretical stages of the credit cycle
based on historical analysis of credit spreads and their relation to macro fundamentals.
Second, after reviewing the macro dynamics of the credit cycle, we develop a leading indicator to predict the
different stages of the cycle, and assess whether the historical performance of credit markets maps intuitively
across these predicted regimes.

Our results are in line with expectations and have important implications for investors. By focusing on relevant macro
fundamentals, dynamic investors can reposition portfolios in anticipation of rare but meaningful episodes of under-
performance in credit markets, mitigating downside risks while improving long-term total returns.

Credit Cycle Regimes and Market Performance: A Theoretical Framework


In hindsight, historical cycles in credit spreads have followed a sequence of three stages (summarized in
Exhibit 1 and illustrated in Exhibit 2 ), characterized by the following macro dynamics and market
return characteristics:

Exhibit 1: The Three Stages of the Credit Cycle: A Theoretical Framework

Beginning of the Cycle Mid-Cycle End of the Cycle

Spreads Major Compression Low and Stable Major Widening


High from price appreciation and Moderate primarily from
Returns Poor price losses exceed income
income income
Frequency 12% of the time 62% of the time 26% of the time

Sources: Bloomberg, OppenheimerFunds, Inc. 12/31/15. See Exhibit 2 for data source. Past performance does not guarantee future results.

Beginning of the Cycle: At the end of recessions, credit spreads tend to tighten sharply over a short period
of time, usually just a few quarters, in response to stabilization in economic activity, aggressive monetary
policy easing and loosening lending standards. Examples of these episodes occurred in 1991, 2003 and in
2009. In terms ofasset returns, this phase sees credit outperform government bonds due to both strong price
appreciation andhigher income.

2
The Right Way to Invest

Mid-Cycle: As the economy continues to improve, ample credit creation supports investment spending and
employment growth. As the corporate sector begins to relever, monetary policy gradually begins to tighten in
response to stronger labor markets and rising inflation. In this environment, spreads stabilize around or below
their historical long-term average, exhibiting low volatility for several years. While credit markets may still
experience occasional turbulence, by and large these spread-widening episodes are short lived, not associated
with rising default rates, and quickly reversed. As shown in Exhibit 2 , this kind of regime occurred between
1992 and 1997, between 2004 and mid-2007, and between 2010 and 2014. From an investment standpoint,
valuations may seem expensive due to tight spreads. However, this phase actually represents an attractive carry
environment in which the case for credit is mostly centered on earning income, rather than expectations of
priceappreciation.
End of the Cycle: Finally, credit markets enter what we call the end of the credit cycle. After years of debt
accumulation in the system, high leverage increases the vulnerability of the corporate sector to external shocks
such as slowing economic growth, tightening lending standards, and so on. These shocks can cause credit
spreads to widen aggressively with persistent momentum, leading to rating downgrades, rising default rates
and credit contraction. Examples of this regime occurred between 1998 and 2002, and from mid-2007 through
2008. In this third phase, higher-quality credit outperforms and credit markets substantially underperform
governmentbonds.

After modeling the macro dynamics within the credit cycle, we develop an empirical framework to measure and
predict the three stages of the cycle in real time. Finally, we assess whether the performance of credit markets maps
intuitively across these different regimes.

Exhibit 2: The Three Stages of the Credit Cycle: A Historical Perspective

Investment Grade Credit Spreads


Q1 1989 Q4 2015
6%

0
1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

Credit Spreads Historical Average Spreads Beginning of the Cycle Mid-Cycle End of the Cycle

Sources: Bloomberg, Moodys, OppenheimerFunds, Inc., 12/31/15. Expanding average calculation of the spread begins January 1965. Spread regimes are
defined expost with perfect foresight. Investment Grade credit spreads are represented by the BAA-UST 30 Year Spreads. See last page for index definitions.
Pastperformance does not guarantee future results.

3
OppenheimerFunds

A Macro Framework of the Credit Cycle


We now describe the typical macro dynamics across the three stages of the credit cycle and identify key economic
variables that we believe are best suited to proxy these relationships.

The credit cycle originates from monetary policy. When the economy is coming out of a recession, accommodative
monetary conditions incentivize bank lending and credit creation. As a proxy of monetary policy stance, the slope of
the yield curve provides direct information on current financing conditions and profit margins available to banks (Balla
et al., 2007), with a steeper (flatter) term structure indicative of easier (tighter) policy. As a result, the yield curve is
one of the most reliable leading indicators of the credit and business cycle, with long lead times due to the lagged
effects of monetary policy on the economy. At the beginning of the cycle, credit creation leads to a compression in
credit spreads and improving economic activity.1

As the economy enters an expansionary phase, corporate borrowing continues to grow, financing investments and
employment growth. Over time, this gradual process of debt accumulation leads to rising levels of leverage in the sys-
tem, while monetary policy begins to tighten in response to stronger labor markets and rising inflationary pressures.
This gradual and steady tightening process feeds into the real economy over the course of several years until a flatter
yield curve no longer encourages bank lending. As the credit impulse decelerates, economic growth slows.2 At this
point, higher leverage ratios expose the vulnerabilities of the corporate sector to economic shocks, raising ques-
tions about debt sustainability and viability of investment projects. A combination of restrictive monetary conditions,
slowing economic prospects and higher leverage leads banks to tighten lending standards, causing credit spreads
to widen. Rising funding costs and the inability to roll over debt further exacerbate stress in the corporate sector,
leading to higher default rates. The ensuing recession leads to deleveraging, a new cycle of monetary easing, and the
beginning of a new credit cycle.

A stylized representation of the credit cycle can be summarized in Exhibit 3 , where the main drivers identified
above are dynamically influencing one another at different time lags.

Exhibit 3: Understanding the Three Stages of the Credit Cycle

A Stylized Summary of Macro Conditions

Beginning of the Cycle Mid-Cycle End of the Cycle


M om
Credit Spreads

ad
aj o p r
C

p re g
r S es s

r S nin
aj o d e
pr io

M Wi
ea n

Low and Stable Spreads


d

Average

Time
Monetary Policy Accommodative Normalizing Tight

Leverage Deleveraging Rising Excessive


Economic Activity Improving Expanding Deteriorating
Lending Standards Easing Generous Tightening

A simple correlation analysis, presented in Exhibit 4 , confirms the strong relationship between these four variables
and credit spreads. All correlation coefficients have a sign that is consistent with our analysis above, and are statisti-
cally significant. In particular, there is a positive relationship between lending standards and credit spreads, in which
rising lending standards (i.e., tightening) are associated with widening spreads. As expected, economic growth and
spreads are negatively correlated. Both leverage and the yield curve seem to lead long-term cycles in credit spreads,
with the former exhibiting a positive correlation and the latter exhibiting a negative one. Moreover, the lead time of each
variable is indicative of economic relationships that can be exploited to predict future movements in creditmarkets.3

1. See for example Estrella and Mishkin (1996) and Estrella and Trubin (2006). Moreover, Rudebusch and Williams (2009) document the enduring feature of
this phenomenon over time, and provide evidence that simple yield curve-based forecasts of recessions outperform subjective forecasts from the Survey
ofProfessional Forecasters.
2. The credit impulse refers to the change in credit growth, and it is found to be highly correlated with GDP growth (see Biggs et al (2009)).
4 3. In addition, for a more comprehensive empirical analysis of the credit cycle, we quantify these relationships and the lead-lag effects between these variables
in a Vector Autoregression model (details available upon request).
The Right Way to Invest

Exhibit 4: Macro Drivers of Corporate Credit Spreads

Sample Q1 1967 Q4 2015


Correlation T-Stat* Lead Time
Monetary Policy 0.43 6.61 8 quarters

Leverage 0.27 3.85 3 quarters


Economic Activity 0.52 8.58 1 quarter
Lending Standards 0.37 5.46 1 quarter
*All variables significant at 99% confidence level

Source: OppenheimerFunds, 12/31/15.

Exhibit 5 provides more details on the data used to proxy these variables.

Exhibit 5: Variables and Data Description

Corporate Credit Spreads: We use the spread between the Moodys Corporate BAA Yield-to-Maturity Index and
the U.S. 30-year Treasury yield-to-maturity. We chose the 30-year Treasury to obtain the closest duration equiv-
alent to the Moodys Index. While the long-end of the curve is not necessarily the most representative segment of
the investment-grade universe, the choice was dictated by data availability, with Moodys providing the longest
time series history of corporate bond yields.

Monetary Policy Conditions: We proxy the stance of monetary policy using the slope of the yield curve, mea-
sured as the difference between the U.S. 10-year Treasury yield-to-maturity minus the U.S. 3-month Treasury
yield-to-maturity.

Leverage: We construct a proprietary measure of U.S. non-financial corporate debt, measuring deviations of
real debt-to-potential GDP from its long-term trailing average, therefore extracting the cyclical component of the
leverage cycle.

Economic Activity: We use the ISM Manufacturing PMI Index to proxy U.S. economic activity, given their his-
torically strong positive correlation. We prefer ISM over U.S. GDP growth because it is not subject to substantial
revisions and it is released in a timely manner.4

Lending Standards: We refer to lending standards as a broad measure of credit terms, where the price of credit is
expressed not only with a loan rate, but also through a range of other lending terms. Loan officers can increase or
decrease the availability of credit via different metrics, as they adjust to changes in actual or perceived credit risk.
These metrics include maturity, collateral, covenants, loan limits, etc. (see Lown and Morgan, 2006). This compre-
hensive notion of lending standards is well captured by the Federal Reserves Senior Loan Officer Opinion Survey
on Bank Lending Practices (SLOOS), which measures the net percentage of loan officers reporting a tightening in
lending standards over the quarter.

5
4. The historical correlation of the level of ISM with year-over-year real GDP growth from 19482013 is 0.60.
OppenheimerFunds

A Closer Look at These Variables During the Credit Crisis


Using the credit cycle between 2001 and 2008 as an example, we provide a visual representation of these variables
and their relationship to credit spreads.

Beginning of the Credit Cycle (20022003): In response to the U.S. recession in 2001, the Federal Reserve
aggressively eased monetary policy, causing a rapid steepening in the yield curve which moved from an inverted posi-
tion to a positive spread of 300bps between 10-year and 3-month bond yields (Exhibit 6 ). Such steepness lasted
throughout 2002 and 2003, improving bank profitability and the supply of credit. Over this period, the corporate
sector continued the deleveraging process that started at the end of the recession, further improving long-term cor-
porate fundamentals (Exhibit 7 ). These conditions facilitated a rebound in economic activity and a steady easing in
lending standards, as demonstrated by the ISM survey rebounding from the low 40s to the high 50s (Exhibit 8 ) and
the steady decline in the percent of loan officers reporting a tightening in lending standards, from 50% to 20%
(Exhibit 9 ). Corporate credit spreads tightened rapidly between 2002 and 2003 from roughly 270 basis points down
to 130 basis points.

Mid-Cycle (2004 to mid-2007): With the economy on a stronger footing, the Federal Reserve began a gradual tight-
ening process in 2004. Policy normalization led to a steady flattening of the yield curve; however, it remained upward
sloping throughout 2004 and 2005, signaling that monetary policy was still accommodative (Exhibit 6 ). Infact,
the economy continued to grow at a steady pace, as shown by the ISM survey, which, while slowing, remained well
into expansionary territory (i.e., above 50) between 2004 and early 2007 (Exhibit 8 ). Similarly, lending standards
continued to ease over the same 3-year period (Exhibit 9 ), while the corporate sector began to re-leverage in
mid-2005 (Exhibit 7 ). Throughout this period, credit spreads remained in a broadly stable range between 130bps
180bps, offering an attractive carry environment with low volatility. However, by the end of this period monetary
policy had become too restrictive, causing the yield curve to invert between July 2006 and May 2007. These were the
first signs of new risks building in the credit cycle.

End of the Credit Cycle (Mid-2007 to 2008): The prolonged inversion of the yield curve between July 2006 and May
2007 was an important indication of monetary policy being too tight. Given the long lag between policy and the real
economy (even up to two years as shown in Exhibit 5), lending standards began to tighten and economic activity to
weaken substantially in the second half of 2007 (Exhibits 8 and 9 ). In addition, debt-to-GDP continued to rise until
early 2008, increasing the vulnerability of the corporate sector in the face of slowing growth and tightening lending
standards (Exhibit 7 ). In the fall of 2007, credit spreads widened beyond the range that held in the previous three
years, pricing in the deteriorating growth outlook, weaker balance sheets and tightening credit conditions. Credit
markets continued to underperform over the course of 2008, culminating in the final sell-off in Q4-2008, caused by
the bankruptcy of Lehman Brothers and the ensuing global financial crisis. Authorities around the world responded
with unprecedented monetary and fiscal policy support, stabilizing confidence and planting the seeds of a new credit
cycle that began in early 2009.

Exhibit 6: Monetary Policy Conditions Eight-Quarter Warning Signal


July 2001 July 2009
Beginning of the Cycle Mid-Cycle End of the Cycle
6% 4%
Steep Yield Curve
5 3
Major Spread Widening
4 Steep
2 Curve
3 Spread Compression
1
2
Flat
1 0 Curve
Earliest Warning Signal:
Flattening & Inversion of the Yield Curve Inverted
0 1 Curve
Jul. 01

Oct. 01

Jan. 02

Apr. 02

Jul. 02

Oct. 02

Jan. 03

Apr. 03

Jul. 03

Oct. 03

Jan. 04

Apr. 04

Jul. 04

Oct. 04

Jan. 05

Apr. 05

Jul. 05

Oct. 05

Jan. 06

Apr. 06

Jul. 06

Oct. 06

Jan. 07

Apr. 07

Jul. 07

Oct. 07

Jan. 08

Apr. 08

Jul. 08

Oct. 08

Jan. 09

Apr. 09

Jul. 09

Credit Spreads (Left) Yield Curve (Right)

Sources: Bloomberg, Federal Reserve, Moodys, OppenheimerFunds, Inc. 12/31/15.

6
The Right Way to Invest

Exhibit 7: Leverage Three-Quarter Warning Signal


July 2001 July 2009
Beginning of the Cycle Mid-Cycle End of the Cycle
6% 4%
Decreasing Leverage

Above Trend
Major Spread Widening 3
5
2
4 1
3 0
Spread Compression Early Warning Signal:
1

Below Trend
2 Increasing Leverage
2
1
3
0 4
Jul. 01

Oct. 01

Jan. 02

Apr. 02

Jul. 02

Oct. 02

Jan. 03

Apr. 03

Jul. 03

Oct. 03

Jan. 04

Apr. 04

Jul. 04

Oct. 04

Jan. 05

Apr. 05

Jul. 05

Oct. 05

Jan. 06

Apr. 06

Jul. 06

Oct. 06

Jan. 07

Apr. 07

Jul. 07

Oct. 07

Jan. 08

Apr. 08

Jul. 08

Oct. 08

Jan. 09

Apr. 09

Jul. 09
Credit Spreads (Left) Real Corp. Debt to GDP (Right)

Sources: Bloomberg, Federal Reserve, Moodys, OppenheimerFunds, Inc. 12/31/15.

Exhibit 8: Economic Activity One-Quarter Warning Signal


July 2001 July 2009
Beginning of the Cycle Mid-Cycle End of the Cycle
6% 65

Expansion
5 Slowing Economic 60
Growth
4 55

3 50

Contraction
2 45

1 40

0 35
Jul. 01

Oct. 01

Jan. 02

Apr. 02

Jul. 02

Oct. 02

Jan. 03

Apr. 03

Jul. 03

Oct. 03

Jan. 04

Apr. 04

Jul. 04

Oct. 04

Jan. 05

Apr. 05

Jul. 05

Oct. 05

Jan. 06

Apr. 06

Jul. 06

Oct. 06

Jan. 07

Apr. 07

Jul. 07

Oct. 07

Jan. 08

Apr. 08

Jul. 08

Oct.08

Jan. 09

Apr. 09

Jul. 09

Credit Spreads (Left) ISM (Right)

Sources: Bloomberg, Federal Reserve, Moodys, OppenheimerFunds, Inc. 12/31/15. ISM Manufacturing PMI Index is an indicator of the economic health of the
manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.

Exhibit 9: Lending Standards One-Quarter Warning Signal


July 2001 July 2009
Beginning of the Cycle Mid-Cycle End of the Cycle
6% 100

5 80
Net Tightening

60
4 Tightening Lending
Standards 40
3
20
2
0
Net Easing

1 20
0 40
Jul. 01

Oct. 01

Jan. 02

Apr. 02

Jul. 02

Oct. 02

Jan. 03

Apr. 03

Jul. 03

Oct. 03

Jan. 04

Apr. 04

Jul. 04

Oct. 04

Jan. 05

Apr. 05

Jul. 05

Oct. 05

Jan. 06

Apr. 06

Jul. 06

Oct. 06

Jan. 07

Apr. 07

Jul. 07

Oct. 07

Jan. 08

Apr. 08

Jul. 08

Oct. 08

Jan. 09

Apr. 09

Jul. 09

Credit Spreads (Left) C&I Lending Standards (Right)

Sources: Bloomberg, Federal Reserve, Moodys, OppenheimerFunds, Inc. 12/31/15. See last page for information on C&I Lending Standards.

7
OppenheimerFunds

A Leading Indicator of the Credit Cycle


We investigate the usefulness of our macro framework from an investment standpoint, testing its ability to predict
turning points in the credit cycle. Our objective is to determine, on a quarterly basis, which stage of the cycle we are
in, and to predict the occurrence of the next regime. We take the perspective of an investor with a long-term invest-
ment horizon and a bias to be long credit over government bonds, therefore earning the credit risk premium over
time. In other words, we are not concerned about short-term fluctuations in credit spreads. Instead, we are interested
in avoiding the end of the credit cycle (i.e., the third stage), a regime in which credit markets are likely to experience
large and persistent drawdowns, underperforming government bonds.

Using our proprietary model, we develop a probability-based leading indicator of the credit cycle. This indicator,
illustrated in Exhibit 10 , can be interpreted as the probability that credit markets will experience significant spread
widening in the near future, associated to deteriorating macro fundamentals.5

Exhibit 10: GMAG Credit Cycle Leading Indicator

Probability of Major Spread Widening in the Next Quarter (Out of Sample)


Q1 1989 Q1 2016
100% 6
90
5
80
70
Very High 4
Credit 60
Risk
50 3
High
Credit 40
Risk 2
30
20
Low 1
Credit 10
Risk
0 0

Q1 2010

Q1 2011

Q1 2012

Q1 2013

Q1 2014

Q1 2015

Q1 2016
Q1 1989

Q1 1990

Q1 1991

Q1 1992

Q1 1993

Q1 1994

Q1 1995

Q1 1996

Q1 1997

Q1 1998

Q1 1999

Q1 2000

Q1 2001

Q1 2002

Q1 2003

Q1 2004

Q1 2005

Q1 2006

Q1 2007

Q1 2008

Probability (Left) Credit Spreads (Right) Historical Average Spreads Q1 2009

Sources: Bloomberg, Moodys, OppenheimerFunds, Inc., 12/31/15. One-quarter-ahead probabilities of a spread widening event. Quarterly Moodys Corp. BAA
yield-to-maturity minus U.S. 30-year Treasury yield-to-maturity is on the right axis.

Overall, the model performed well in anticipating the major credit events experienced since 1989, namely the two
credit crises of 19982001 and 20072008, with the indicator rising sharply a few quarters ahead of the actual
widening in spreads. Similarly, our probability measure dropped rapidly towards the end of such episodes, signal-
ing the increased likelihood of a recovery in credit markets. The model missed the spread widening that occurred
between the second half of 2011 and the first half of 2012, when our probability estimate rose to only 20%. We do
not find this surprising, since market turbulence over that period was caused by the European sovereign debt crisis,
and not by U.S. macro credit fundamentals. Therefore, an interpretation of our signal at the time would have likely

5. This probability indicator is constructed using out-of-sample estimation of a probit model, running regressions on a quarterly basis with an expanding sample
starting from Q1-1967 to Q4-1988 and ending in Q1-1967 to Q4-2015. A probit model is an econometric regression method to estimate the probability that an
8 observation with particular characteristics will fall into one of two defined categories. We use only data available at the time of estimation, therefore avoiding any
look-ahead bias. Details available upon request.
The Right Way to Invest

suggested a buying opportunity. Similarly, the indicator did not anticipate the credit turbulence that began in the
second half of 2014, which was initially caused by stress in the high yield energy sector and later affected overall
credit markets. However, the probability quickly rose to warning levels, settling between 30%60% in the following
four quarters, validating the price action in credit spreads, which experienced additional underperformance through-
out 2015, particularly in high yield.

Historical Performance of Predicted Credit Cycle Regimes


We define the three stages of the cycle in real-time based on the level of our probability indicator and the level of
credit spreads versus their long-term average. The rules for our regimes definitions are outlined in Exhibit 11, using
aprobability threshold of 50%. The choice of a 50% threshold is inherently subjective, in this case simply represent-
ing even odds, and it is shown for illustrative purposes. However, as shown in the appendix, our results are robust to
awide range of thresholds, confirming the validity of our methodology.

Next, we back-test the historical performance of the credit risk premium in these predicted regimes and assess
whether credit returns map consistently with our expectations. In other words, we determine whether our probability
indicator is able to anticipate turning points in the credit cycle and, therefore, in credit markets.

Results are reported in Exhibit 11 using investment grade and high yield benchmarks.6

Exhibit 11: Predicting the Three Stages of the Credit Cycle: Investment Implications

Average Annualized Excess Returns Over Government Bonds Risk-Adjusted Returns


January 1989 December 2015 January 1989 December 2015

Beginning of the Cycle Mid-Cycle End of the Cycle Beginning of the Cycle Mid-Cycle End of the Cycle
Spread Compression Stable Spreads Spread Widening Spread Compression Stable Spreads Spread Widening

15% 1.2 1.1 1.1


12.1
12 1.0
Information Ratios

0.8 0.7
9
Excess Return

6 4.5 4.4
0.6
0.4 0.2
3 0.4 0.2
0 0.0
3 2.2 0.2
6 0.4
0.4
9 7.5 0.6 0.6
Investment Grade Risk Premium High Yield Risk Premium Investment Grade Risk Premium High Yield Risk Premium
Credit Regime Description

Beginning of the Cycle: If the probability of a major spread widening is below 50% and the current spread is above
Major Spread Compression its long-term average: expect major spread compression.
Mid-Cycle: If the probability of a major spread widening is below 50% and the current spread is at or
Low and Stable Spreads below its long-term average: expect low and stable spreads.
End of the Cycle: If the probability of a major spread widening is equal to or higher than 50% (regardless of
Major Spread Widening the current spread level): expect major spread widening.

Sources: Bloomberg, OppenheimerFunds, Inc. 12/31/15. Note: Monthly return series over the period 1/8912/15. The probit probability threshold for widening
regimes is set to 50% and quarterly probabilities are held constant for three months. Investment Grade Risk Premium series is the Barclays IG Corp. Excess Return
(ER) Index. High Yield Risk Premium is the JPMorgan HY Corp. Total Return (TR) Index (backfilled with Credit Suisse HY Corp. Index prior to 2/95) minus a duration-
matched U.S. Treasury TR series. See last page for index definitions. Past performance does not guarantee future results.

6. 
To be conservative and realistically out-of-sample, the backtest assumes an additional delay of three to four weeks with respect to the release of the Fed SLOOS.
For example, given the January 2015 survey, released on February 2, 2015, we use the associated probability forecast only at the end of February 2015, to 9
determine the credit regime starting in March 2015.
OppenheimerFunds

The main highlights are as follows:


Beginning of the Cycle: Major Spread Compression: This is the least frequent of the three stages, with only
21% of observations since 1989. As expected, this regime delivers the highest excess returns over government
bonds, with credit benefiting from both price appreciation and income.
Mid-Cycle: Stable Spreads: This is the most frequent and persistent state of credit markets, with about 50%
ofobservations. Excess returns are substantially lower than in the first stage, but still positive. For both investment
grade and high yield, performance is mostly coming from the additional yield (i.e., the carry) earned over govern
ment bonds in a stable market environment, without significant contribution from price appreciation. In other
words, despite tight credit spreads and limited upside, credit still offers better returns, and risk-adjusted returns,
than government fixed income.
End of the Cycle: Major Spread Widening: With 29% of occurrence since 1989, this regime tends to deliver
outright negative returns. Credit clearly underperforms government bonds, as large spread widening causes
price losses in excess of income. Results are directionally consistent between investment grade and high yield.

Overall, this analysis confirms our expectations and provides strong support to the validity of our macro framework.
The performance of the credit risk premium maps very intuitively into the predicted stages of the credit cycle, and it is
directionally consistent between the two credit universes. In addition, our results are robust to alternative probability
thresholds, suggesting that our analysis is not sensitive to a subjective parameter choice (see appendix for back-
tests using 30% and 40% thresholds).

Conclusions
Our study provides a macro framework to understand the different stages of the credit cycle and the typical behavior
of credit spreads in each regime. Our representation of the cycle is summarized in four variables that impact credit
spreads: the yield curve, debt, economic growth and lending standards. The yield curve is the most forward-looking
variable in the system, and a reminder that the credit cycle begins with monetary policy. Our analysis sheds light on
the role of leverage in the cycle, where excessive debt is a manifestation of deteriorating fundamentals, but lever-
age itself is not the trigger of credit underperformance. Instead, slowing economic growth and tightening lending
standards are often the final catalysts of meaningful spread widening. We believe this is an important distinction from
an investors perspective. In fact, it is very tempting to conclude that the credit cycle is approaching its end when
aggregate leverage is rising and spreads are historically tight; however, such conclusion fails to properly discount
the long time lags by which leverage affects the system. A premature exit from the credit risk premium may feel like
the safer strategy, but it can lead to several quarters (or years) of yield premium being forgone, which is an expensive
proposition in a competitive investment landscape.

The output of our analysis is represented by a proprietary leading indicator of turning points in credit markets, and
is part of a well-structured system of tools designed to give us insights into drivers of financial markets. While our
business cycle regimes analysis aims at anticipating accelerations and decelerations in economic activity, our credit
cycle framework helps us monitor long-term drivers of the risk environment, which is tightly linked to aggregate
leverage in the economy. Our results offer strong evidence that this methodology can be used to guide investment
decisions, manage downside risks and improve long-term risk-adjusted performance.

10
The Right Way to Invest

Appendix
Threshold Robustness Analysis: 40% and 30% Probability Thresholds
We performed robustness analysis on our out-of-sample backtests, varying the probability threshold level which
signals a spread widening regime. In particular, we lowered the threshold from the baseline case of 50% to 40% and
30% cutoffs. Results are reported in Exhibit 12 and Exhibit 13 confirming that this macro framework is stable and
robust to subjective threshold selections.

Exhibit 12: Credit Risk Premium Performance at 40% Probability Threshold (Out of Sample)

Average Annualized Excess Returns Over Government Bonds Risk-Adjusted Returns


January 1989 December 2015 January 1989 December 2015

Beginning of the Cycle Mid-Cycle End of the Cycle Beginning of the Cycle Mid-Cycle End of the Cycle
Spread Compression Stable Spreads Spread Widening Spread Compression Stable Spreads Spread Widening
1.2
15% 1.2 1.1
12.8
12 1.0
Information Ratios

0.8
0.6
Excess Return

9
0.6
6 5.1
4.2 0.4 0.2
3 0.2
0.3 0.0
0
0.2
3 1.8 0.4 0.3
6 5.5 0.6 0.5
Investment Grade Risk Premium High Yield Risk Premium Investment Grade Risk Premium High Yield Risk Premium

Sources: Bloomberg, OppenheimerFunds, Inc. 12/31/15. Note: Monthly return series over the period 1/89 12/15. The probit probability threshold for widening
regimes is set to 40% and quarterly probabilities are held constant for three months. Investment Grade Risk Premium series is the Barclays IG Corp. ER Index.
HighYield Risk Premium is the JPMorgan HY Corp. TR Index (backfilled with Credit Suisse HY Corp. Index prior to 2/95) minus a duration-matched U.S. Treasury
TRseries. See disclosures for index definitions.

Exhibit 13: Credit Risk Premium Performance at 30% Probability Threshold (Out of Sample)

Average Annualized Excess Returns Over Government Bonds Risk-Adjusted Returns


January 1989 December 2015 January 1989 December 2015

Beginning of the Cycle Mid-Cycle End of the Cycle Beginning of the Cycle Mid-Cycle End of the Cycle
Spread Compression Stable Spreads Spread Widening Spread Compression Stable Spreads Spread Widening
1.2 1.2
15% 13.0 1.2
12 1.0
Information Ratios

0.8
Excess Return

9 0.6
5.5 0.6
6 3.8 0.4
3 0.2
0.3 0.2
0 0.0
3 1.3
3.1 0.2
6 0.4 0.3 0.3
Investment Grade Risk Premium High Yield Risk Premium Investment Grade Risk Premium High Yield Risk Premium

Sources: Bloomberg, OppenheimerFunds, Inc. 12/31/15. Note: Monthly return series over the period 1/89 12/15. The probit probability threshold for widening
regimes is set to 30% and quarterly probabilities are held constant for three months. Investment Grade Risk Premium series is the Barclays IG Corp. ER Index.
HighYield Risk Premium is the JPMorgan HY Corp. TR Index (backfilled with Credit Suisse HY Corp. Index prior to 2/95) minus a duration-matched U.S. Treasury
TRseries. See disclosures for index definitions.

11
Alessio de Longis, CFA
Portfolio Manager, Global Multi-Asset Group

Alessio de Longis, CFA, is a Portfolio Manager for the Global


Multi-Asset Group (GMAG), which he joined in October 2013.
Additionally, Mr. de Longis leads the groups macro strategy,
focusing on business cycle dynamics, global macro regimes, and
their impact on asset class risks and returns. He also manages
active currency strategies in GMAGs funds. From 2004 to 2013,
he was a member of the Global Debt team.

About the Global Multi-Asset Group

OppenheimerFunds Global Multi-Asset Group (GMAG) is led by Mark Hamilton, the firms
Chief Investment Officer for Asset Allocation and Alternatives. Mark serves as the lead Portfolio
Manager on the firms suite of risk-aware dynamic allocation strategies and is supported by three
co-portfolio managers and a team of dedicated analysts. GMAGs culture is built on the belief
thatcombining multiple independent perspectives builds resiliency in an investment process,
andhelps to avoid blind spots. Accordingly, GMAG combines distinct, complementary views across
macro, risk and market analysis within a structured decision-making process. Each of these three
perspectives is developed independently by separate research teams in order to avoid group think.
Visitoppenheimerfunds.com/gmag to learn more.

References
Balla, Eliana, and Carpenter, Robert E., and Mark D. Vaughan. 2007. Decoding Messages from the Yield Curve. Region Focus, Federal Reserve
Bank of Richmond, vol. 11, no. 2 (Spring): 37-39.
Biggs, Michael, and Mayer, Thomas, and Andreas Pick. 2009. Credit and Economic Recovery. De Nederlandsche Bank Working Paper, no. 218 (July).
Estrella, Arturo, and Frederic S. Mishkin. 1996. The Yield Curve as a Predictor of U.S. Recessions. Current Issues in Economics and Finance,
Federal Reserve Bank of New York, vol. 2, no. 7 (June).
Estrella, Arturo, and Mary R. Trubin. 2006. The Yield Curve as a Leading Indicator: Some Practical Issues. Current Issues in Economics and
Finance, Federal Reserve Bank of New York, vol. 12, no. 5 (July).
Lown, Cara and Donald Morgan. 2006. The Credit Cycle and the Business Cycle: New Findings Using the Loan Officer Opinion Survey. Journal of
Money, Credit and Banking, Blackwell Publishing, vol. 38, no. 6 (September):1575-1597.
Rudebusch, Glenn D., and John C. Williams. 2009. Forecasting Recessions: The Puzzle of the Enduring Power of the Yield Curve. Journal of
Business and Economic Statistics, American Statistical Association, vol. 27, no. 4:492-503.
Index Definitions
BAAUST 30Y: Quarterly Moodys Corp. BAA yield-to-maturity minus U.S. 30-year Treasury yield-to-maturity. The Moodys Corp BAA Index is
derived from a universe of bonds with maturities as close as possible to 30 years, excluding any bond with a remaining maturity of less than 20
years. There is no 30-year Treasury data prior to 2/15/77; therefore, we backfill the history back to 1966 using the 10-year Treasury rate.
C&I Lending Standards: We use the question on standards for commercial and industrial (C&I) loans to large- and middle-size firms. The C&I
question in its current form dates back to the 1960s, excluding a brief halt between 1984Q1 and 1990Q1. This data is available from the Federal
Reserve only from the re-inception point of the survey in 1990Q2. However, Donald Morgan of the Federal Reserve Bank of New York maintains the
original series at http://newyorkfed.org/research/economists/morgan/pub.html. To fill the gap, we use a similar survey pertaining to loan officers
willingness to make consumer installment loans, which dates back to the 1960s without interruptions (see Owens and Schreft (1991) for further
detail). We regress the original C&I series on contemporaneous values of the consumer installment series and lagged values of our debt variable
and use estimated coefficients to backfill the C&I series from 1984Q1 to 1990Q1.
The Federal Reserves Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) measures the net percentage of loan officers
reporting a tightening in lending standards over the quarter.
The Barclays IG Corp. ER Index is defined as the return of the Barclays U.S. Aggregate Bond Index minus a duration-matched U.S. Treasury TR series.
The JPMorgan HY Corp. Total Return (TR) Index is a dollar-denominated index consisting of non-investment-grade corporate bonds, which are
issued by both U.S. and non-U.S. companies.
The Credit Suisse HY Corp. Index tracks the performance of domestic non-investment-grade corporate bonds.
Indices are unmanaged and cannot be purchased directly by investors.
Mutual funds are subject to market risk and volatility. Shares may gain or lose value.
Fixed income investing entails credit and interest rate risks. When interest rates rise, bond prices generally fall.
Shares of Oppenheimer funds are not deposits or obligations of any bank, are not guaranteed by any bank, are not insured by the FDIC
or any other agency, and involve investment risks, including the possible loss of the principal amount invested.
Visit Us
This material is provided for general and educational purposes only, and is not intended to provide legal, tax or investment advice, or for use to
oppenheimerfunds.com avoid penalties that may be imposed under U.S. federal tax laws. Contact your attorney or other advisor regarding your specific legal, investment
ortaxsituation.
Call Us Before investing in any of the Oppenheimer funds, investors should carefully consider a
800 225 5677 funds investment objectives, risks, charges and expenses. Fund prospectuses and summary
prospectuses contain this and other information about the funds, and may be obtained by asking
Follow Us your financial advisor, visiting oppenheimerfunds.com or calling 1 800 CALL OPP (225 5677).
Read prospectuses and summary prospectuses carefully before investing.
Oppenheimer funds are distributed by OppenheimerFunds Distributor, Inc.
225 Liberty Street, New York, NY 10281-1008
2016 OppenheimerFunds Distributor, Inc. All rights reserved.
ND0000.058.1016 December 14, 2016