Credit Cycle and Risk Appetite: Spreads as a Leading Indicator

The credit cycle — expansion, peak, contraction, trough — leads the equity cycle by months. Credit spreads widen before equities peak and tighten before equities bottom, making credit a leading indicator of risk appetite.

The Four Phases

• Expansion: lending standards ease, HY issuance rises, covenants weaken, spreads tighten below 350 bps. Cyclicals and small-caps outperform.
• Peak: defaults still low but leverage at cycle highs; curve flattens or inverts; spreads stop tightening despite low defaults — a divergence warning. Leadership narrows to quality and mega-cap.
• Contraction: defaults rise; spreads widen sharply (HY OAS often >600 bps, distress >1,000 bps); correlations spike; risk-off rotation into duration and defensives; primary market shuts.
• Trough: defaults peak; policy eases; spreads wide but stable; risk-on rotation resumes with cyclical and high-beta credit leading.

The Key Indicator: High-Yield OAS

The ICE BofA US High Yield Index OAS measures compensation for default risk over Treasuries.

HY OAS Level	Regime	Equity Read
<350 bps	Complacent / late cycle	Narrow leadership; reduce beta
350–500 bps	Normal expansion	Risk-on; broad participation
500–700 bps	Stress building	Defensive tilt; raise cash
700–1,000 bps	Recession / distress	Risk-off; duration and quality
>1,000 bps	Capitulation / trough	Contrarian accumulation

The 2020 COVID spike took OAS from ~390 to ~1,100 bps in five weeks; the March 23 equity low coincided with peak widening. In 2008 OAS exceeded 2,000 bps at the March 2009 equity bottom.

Leading vs Lagging

Leading: HY OAS widening, covenant erosion, distress ratio rising. Coincident: default rate, equity drawdown. Lagging: recovery rate, unemployment. Trade the leading series; the lagging is for narrative.

Risk-On / Risk-Off Rotation

When OAS tightens and distress is low: favor equities, high-yield, EM, cyclical commodities, high-beta FX (AUD, MXN); reduce duration. When OAS widens: favor duration, USD, JPY, defensives, gold; reduce equities and high-yield.

Implementation

1. Weekly chart of HY OAS alongside the S&P 500 — divergences (equities up, OAS widening) are the highest-value signal.
2. Distress ratio (issuers >1,000 bps over): >10% signals stress; >20% signals near-trough.
3. Fed Senior Loan Officer Survey (quarterly): tightening standards lead contraction by 2–4 quarters.
4. S&P 500 net debt/EBITDA above 3.0x marks late-cycle excess.

Action Points

1. Add HY OAS and the distress ratio to a weekly dashboard.
2. Pre-commit regime thresholds (e.g., >600 bps = risk-off tilt).
3. Watch credit-equity divergence as the highest-confidence signal.

The credit cycle does not predict the exact equity top or bottom. It tells you when the risk regime has shifted, which is the only input a rotational trader needs.