2. The credit cycle: spreads and contagion

Macro 5: Debt, credit and crises

Equities take the headlines, but it is credit that runs the economic cycle. A company can survive for years with its share price falling; it cannot survive a week unable to refinance the loan that matures on Friday. That is why the corporate debt market gives warning earlier and with less noise than the equity market, and why it is worth knowing how to read its one essential indicator: the spread.

What a spread is and what it is paying you for

The credit spread is the difference between the yield on a corporate bond and the yield on government debt of the same maturity. It is measured in basis points: one hundred basis points is one percentage point. If a five-year corporate bond yields 6.5% and the five-year Treasury yields 4%, the spread is 250 basis points.

That excess is not a gift. It is paying you for three distinct things worth keeping apart:

• Expected loss from default. The probability that the company fails to pay, multiplied by what you would lose if it does. The second matters as much as the first: the recovery rate on a secured bond is far higher than on subordinated debt with no collateral.
• Illiquidity premium. A corporate bond does not sell when you want and at the price you want. That nuisance is charged for.
• Risk premium proper. The extra the investor demands for bearing uncertainty, which varies enormously with the risk appetite of the moment.

The practical consequence is that a widening spread does not necessarily imply that the market expects more bankruptcies. Very often it implies that the price of fear and of illiquidity has gone up, two things that move far faster than the actual solvency of companies.

The credit cycle in four movements

Charles Kindleberger and Robert Aliber described in *Manias, Panics and Crashes* a pattern that repeats with uncomfortable regularity, and Hyman Minsky supplied the financial mechanism. In brief:

• Expansion. Something real changes, whether a technology, a deregulation or low rates for a long time, and expectations improve. Lending is cheap and lending works.
• Loosening standards. Since nobody is defaulting, criteria slacken. Covenant-lite loans appear, along with interest-only debt and refinancings that depend on the market staying open. Minsky called this the move from hedge finance to speculative finance and on to outright Ponzi finance, where the borrower needs new credit even to pay the interest.
• Turning point. Something shifts: the risk-free rate rises, a sector rolls over, a sizable borrower goes under. Refinancing stops being automatic.
• Contraction. Spreads widen, credit closes and the borrowers who fail are precisely those who depended on it staying open. The contraction validates the fear that caused it.

The point to hold on to is that fragility is built during the good phase. When spreads are at historic lows, it is not that there is no risk: it is that nobody is being paid for it.

High yield: the canary in the mine

High yield, or junk bonds, is the debt of issuers rated below investment grade. These issuers depend on the market to survive: if the primary market closes, they cannot refinance and they go under. That is why their spread is the most sensitive thermometer of the cycle, and why it tends to turn before equities do.

Three things are worth watching besides the level of the spread: the maturity wall (how much debt has to be refinanced over the next two years), the observed default rate, and whether the primary market is still open. A deal pulled for lack of demand says more than any index.

The contagion channel: from the spread to the real economy

This is where credit stops being a matter for bond people. The sequence has three legs that reinforce each other.

First, cost. A higher spread makes refinancing dearer, and the company reacts by cutting investment and headcount to preserve cash. Second, quantity. Banks tighten their lending conditions, and that tightening is measured: the bank lending surveys published by the Federal Reserve and the European Central Bank anticipate the fall in investment several quarters ahead. Third, feedback. Less investment and less employment mean lower revenues, which worsens solvency and justifies wider spreads still.

Add the banking link: credit losses eat capital, and a bank with less capital lends less. Gary Gorton showed that in 2007 and 2008 the panic was not depositors at the counter but wholesale funding: debt that everyone treated as safe stopped being so once it started to matter what was inside it.

Three crises, three readings of the same indicator

• 2008. The US high yield spread started from lows below 250 basis points in 2007 and went beyond 1,800 by December 2008. It was not a warning: it was the complete closure of the market, with defaults running above 10% a year.
• March 2020. The spread shot up to around 1,100 basis points within weeks, and narrowed almost as fast once the Federal Reserve announced it would buy corporate debt, including part of the high yield segment. It was a shock of liquidity and of policy, not a default cycle that ever fully played out.
• 2022. Equities fell hard and the high yield spread barely went past 600 basis points. That contrast is the lesson: the problem in 2022 was the discount rate, not corporate solvency. If credit does not follow an equity sell-off, what you are looking at is probably a repricing, not a crisis.