I have been studying credit cycles for over 50 years. I have watched them unfold in real time, analyzed them in retrospect, and written extensively about their patterns and implications. And I can tell you with considerable confidence that we are approaching a point in the cycle that I have seen before, a point that has historically preceded significant financial stress.
The debt cycle pattern that destroyed wealth in 2008, that crushed investors in 2000 and 2001, that brought down major financial institutions in 1990 and 1991, that pattern is setting up again. Not identically, the specifics are always different, but the fundamental dynamics are the same. And most investors are completely unprepared for what is coming. Let me be very clear about something from the start. I am not predicting a crash. I do not predict crashes. Timing is impossible to know with precision, but I can identify patterns, assess probabilities, and recognize when the conditions for significant stress are building, and those conditions are building.
Now, let me take you through the debt cycle pattern as I have observed it over my career, and then show you exactly where we are in that pattern today. Every debt cycle follows a remarkably similar sequence. It starts with recovery from the previous crisis. Credit conditions are tight. Lenders are conservative. Borrowers are cautious. Interest rates are often low as central banks try to stimulate growth. The memory of recent losses keeps everyone careful.
Gradually, conditions improve. The economy grows. Corporate profits rise. Default rates fall. Lenders start to relax their standards, because the recent experience has been good. Borrowers take on more debt because servicing costs are manageable and times are good. This is where the cycle becomes self-reinforcing. More lending leads to more economic activity. More economic activity leads to better credit performance. Better credit performance leads to more confidence. More confidence leads to more lending. The cycle feeds on itself.
At some point, caution turns to complacency. Lenders convince themselves that the good times will continue. They start competing aggressively for business. Credit standards deteriorate. Loan documentation weakens. Pricing tightens to levels that do not adequately compensate for risk. Borrowers take advantage. They borrow more than they should at terms more favorable than they deserve. Companies that would not have qualified for credit in earlier years suddenly have access to abundant capital. Leverage builds throughout the system.
This is the danger zone. Credit is abundant. Spreads are tight. Risk-taking is elevated. Everyone is making money. No one wants the party to end. Warnings are dismissed as old-fashioned or out of touch. This time is different. People say the old rules do not apply. Then something happens. It might be an economic slowdown, a geopolitical shock, a major company failing unexpectedly, a scandal that shakes confidence. The specific trigger varies from cycle to cycle. But something causes lenders to reassess, borrowers to stumble, confidence to crack.
Once the turn begins, the self-reinforcing dynamics work in reverse. Tighter credit leads to less economic activity. Less economic activity leads to worse credit performance. Worse credit performance leads to less confidence. Less confidence leads to tighter credit. The virtuous cycle becomes vicious. Defaults spike. Lenders suffer losses. Some lenders fail entirely. Credit becomes scarce precisely when borrowers need it most. Asset prices fall. Companies that could easily refinance a year earlier find no one willing to lend. What was manageable debt becomes crushing debt as the ability to service or refinance disappears.
This is the pattern. I have seen it repeat with remarkable consistency throughout my career. The timing varies. The specific sectors involved vary. The severity varies, but the fundamental dynamics are always the same. Let me walk you through some historical examples to show how this pattern has played out.
In the late 1980s, the leveraged buyout boom pushed debt levels to unprecedented heights. Junk bonds funded increasingly aggressive acquisitions. Lending standards deteriorated as competition for deals intensified. Everyone was making money. Concerns about excessive leverage were dismissed. Then the cycle turned. The economy weakened. Several major LBOs ran into trouble. The junk bond market seized up. Drexel Burnham Lambert, the dominant force in high yield finance, collapsed. Default rates spiked to double digits. Investors who had piled into high yield suffered devastating losses.
In the late 1990s, the technology and telecom boom drove massive credit expansion. Companies borrowed billions to build out infrastructure, acquire competitors, and fund growth. Lending standards eroded as lenders chased yields and market share. Credit flowed freely to companies with questionable business models. Then the bubble burst. The NASDAQ collapsed. Telecom companies defaulted in waves. WorldCom, one of the largest corporate borrowers, turned out to be a fraud. Default rates spiked. Credit spreads blew out. The high yield market suffered another brutal downturn.
In the mid 2000s, the housing boom drove the most dramatic credit expansion in history. Mortgage lending standards collapsed entirely. Anyone who could fog a mirror could get a mortgage. Financial engineering created complex securities that obscured the underlying risks. Leverage built up throughout the financial system. Then housing prices stopped rising. Mortgage defaults began to spike. The complex securities built on those mortgages became impossible to value. Confidence evaporated. Bear Stearns failed. Lehman Brothers failed. The entire financial system came within hours of complete collapse.
Each of these episodes followed the same pattern: recovery and caution, followed by expansion and growing confidence, followed by excess and complacency, followed by a trigger event, followed by contraction and crisis. Now, let me show you where we are in the current cycle and why I believe we are approaching the danger zone.
The current credit cycle began in 2009 in the aftermath of the financial crisis. Credit conditions were extremely tight. Banks had nearly failed and were intensely conservative. Private credit barely existed. Default rates were elevated. Everyone was scared. The Federal Reserve responded by cutting interest rates to zero and keeping them there for years. They also implemented quantitative easing, buying trillions of dollars of bonds to push down longer-term rates and stimulate lending. It worked. Credit conditions eased. The economy recovered. Default rates fell. Confidence returned. Lending expanded.
But it did not stop there. The zero-rate environment persisted far longer than anyone expected. For nearly 15 years, money was essentially free. And that changed everything about credit markets. When money is free, the traditional constraints on borrowing disappear. Companies that could never have serviced debt at normal interest rates could easily afford debt at 2 or 3%. Projects that would never have been funded at realistic costs of capital got funded. Leverage that would have been reckless in a normal rate environment seemed manageable.
Private credit exploded. Direct lending funds grew from almost nothing to over a trillion dollars. Private equity firms loaded their portfolio companies with debt. Leveraged loan volumes reached record levels. The floating rate nature of many of these loans meant that borrowers were getting short-term rates that were near zero. Credit standards deteriorated steadily. Covenant light loans, which provide minimal protection for lenders, went from unusual to standard. Documentation became increasingly borrower-friendly. Credit metrics that would have disqualified borrowers a decade earlier became acceptable.
Spreads compressed to levels that did not adequately compensate for risk. The extra yield for taking credit risk fell to near record lows. Investors were so desperate for yield in a zero rate world that they accepted inadequate compensation for the risks they were taking. This was the classic late cycle pattern: abundant credit, deteriorating standards, compressed spreads, elevated risk-taking. All the hallmarks of excess were present.
Then the Federal Reserve raised interest rates at the fastest pace in 40 years. Rates went from zero to over 5% in less than 2 years. The free money era ended abruptly. And here is where we are now in the critical phase where the consequences of the excess become apparent.
Many borrowers took on floating rate debt when rates were near zero. Those borrowers have seen their interest expenses triple or quadruple. Cash flows that easily covered debt service at 3% rates are strained or insufficient at 8 or 9% rates. The ability to refinance has changed dramatically. When credit was abundant and rates were low, even troubled borrowers could refinance and extend their problems. Now credit is tighter and more expensive. Some borrowers cannot refinance at any price.
The maturity wall is approaching. Trillions of dollars of debt comes due in the next few years. Much of it was issued at rates and terms that are no longer available. Borrowers will need to refinance into a much more hostile environment. Default rates have begun to rise. They are still relatively low by historical standards, but the trend is clearly upward. The distressed ratio, the percentage of bonds trading at spreads indicating high default probability, has increased significantly. The conditions for the next phase of the cycle, the contraction phase, are falling into place.
Let me be specific about where I see the greatest risks. Commercial real estate is the most obvious area of stress. Office properties, in particular, face a perfect storm. Remote work has permanently reduced demand for office space. Vacancy rates are at or near record highs in many markets. Rents are falling. Property values have declined 30, 40, even 50% in some cases. Much of this real estate was financed with debt that assumed full occupancy, rising rents, and stable or appreciating values. Those assumptions no longer hold. The loans are underwater. The borrowers cannot refinance. The maturity extensions that kick the can down the road are running out.
Banks hold hundreds of billions of dollars in commercial real estate loans. Regional banks are particularly exposed because commercial real estate is a larger share of their lending. We have already seen some regional bank failures partly related to real estate exposure. More stress is coming. Commercial mortgage-backed securities are also under pressure. These securities package commercial real estate loans and sell them to investors. As the underlying properties struggle, the securities decline in value. Some tranches that were considered safe will take losses.
Leveraged loans are another area of concern. These are loans to heavily indebted companies, often owned by private equity firms. The leveraged loan market has grown enormously over the past 15 years, fueled by the reach for yield in a low rate environment. Many of these loans have floating rates. When rates were near zero, debt service was easily manageable. Now that rates have risen, many borrowers are struggling. Interest coverage ratios have deteriorated. Some companies are now paying more in interest than they generate in operating income.
The covenant-light structure of most leveraged loans means that problems can fester longer before becoming apparent. Traditional loans had covenants that triggered restructuring discussions when credit metrics deteriorated. Covenant light loans allow borrowers to stumble along until they actually miss a payment. By then, the situation is often much worse.
Private credit is a particular area of opacity. Unlike public markets where prices are transparent, private credit is valued by the lenders themselves. There is significant evidence that marks do not fully reflect current conditions. When the reckoning comes, it may be sudden and severe as reality catches up with reported valuations.
Private equity portfolio companies are broadly stressed. Many were acquired at high valuations with significant leverage during the boom years. The combination of high purchase prices, heavy debt loads, and rising interest rates has made many of these investments challenged. The private equity industry has responded by extending hold periods and delaying exits. Distributions to limited partners have slowed dramatically, but this is just postponing the inevitable. Eventually, these companies need to be sold or refinanced. The prices achieved may disappoint.
Beyond specific sectors, I am concerned about the broader transmission mechanism of credit stress. When defaults rise and lenders suffer losses, they become more conservative. They tighten standards, reduce lending, and retreat from risk. This tightening of credit conditions causes further economic weakness, which causes more defaults, which causes more tightening. The downward spiral is self-reinforcing. We saw this dynamic play out dramatically in 2008, but it happens to some degree in every credit cycle downturn.
Credit conditions tighten precisely when borrowers most need access to capital. Companies that could have survived with continued access to credit fail because that access disappears. Small and medium-sized businesses are particularly vulnerable. They depend on bank lending. When banks pull back, these businesses lose their lifelines. They cannot replace bank credit with bond issuances or other alternatives. They simply lose access.
Employment effects follow. Companies under financial stress lay off workers. Reduced employment leads to reduced consumer spending. Reduced consumer spending leads to more business stress. The cycle feeds on itself. Now I want to be careful here. I am not predicting a financial crisis on the scale of 2008. The banking system is better capitalized than it was then. The specific vulnerabilities are different. The policy response would likely be faster and more aggressive. But I am saying that the debt cycle pattern that has repeated throughout history is setting up again.
The excess of the easy money era created vulnerabilities. Those vulnerabilities are now being exposed by higher interest rates. The consequences will play out over the coming years. The timing is uncertain. The depth of the stress is uncertain, but the direction is not. We are moving from the expansion phase of the credit cycle into the contraction phase. That transition is never painless.
Let me now discuss what this means for investors and how to position for what is coming. First, understand that credit cycles create both danger and opportunity. The danger is obvious. If you are holding assets that will suffer during credit stress, you will lose money. If you are leveraged and forced to sell at the wrong time, the losses can be catastrophic. But opportunity also emerges. Distressed assets become available at steep discounts. Companies that just need bridge financing can be supported at attractive terms. Quality assets get sold by forced sellers at prices that bear no relation to intrinsic value.
The investors who do best through credit cycles are those who avoid the worst losses during the contraction and position themselves to capture opportunity when it appears. Second, assess your exposure to credit-sensitive assets. Do you own high yield bonds, leveraged loans, private credit funds, commercial real estate, bank stocks, particularly regional banks, private equity funds with significant leverage? All of these categories face elevated risk as the credit cycle turns. I am not saying sell everything, but understand what you own and the risks involved. Make sure your allocation to these categories reflects a realistic assessment of the cycle phase we are in.
Third, maintain liquidity. Cash and short-term high-quality bonds provide dry powder when opportunities emerge. When everyone else is forced to sell, having cash to buy is enormously valuable. In the late cycle phase we are in now, liquidity has option value. You can deploy it if attractive opportunities appear. If they do not, you earn reasonable returns from short-term treasuries while waiting. The cost of holding liquidity is low and the potential benefit is high.
Fourth, focus on quality. Within any asset category, the highest quality names tend to outperform during periods of stress. Strong balance sheets, durable competitive advantages, essential products and services. These characteristics provide protection when times get tough. This is not the time to reach for yield by going down in quality. The extra return from lower quality credits is minimal during late cycle periods. The extra risk is significant. You are not being compensated for the risks you are taking.
Fifth, understand that the timing of cycles is unpredictable. The conditions I have described could persist for months or years before the acute stress phase arrives, or the trigger could come tomorrow. Do not try to time the cycle precisely. Instead, build a portfolio that can weather stress whenever it arrives. Own high-quality assets. Maintain liquidity. Avoid excessive leverage. These principles serve you well regardless of exactly when the cycle turns.
Sixth, recognize that cycles create generational opportunities. The best investments of my career were made during periods of maximum stress. When credit was scarce, when forced selling created bargains, when pessimism was pervasive. If you are prepared, if you have liquidity, if you have the analytical capability to assess situations and the psychological fortitude to act during stress, you can achieve returns that are simply not available during normal times.
The debt cycle that is unfolding will create these opportunities. The question is whether you will be positioned to take advantage of them. Let me share some historical perspective on how severe the consequences of debt cycle turns can be.
In the downturn of the early 1990s, default rates on high yield bonds exceeded 10%. The savings and loan industry collapsed with over a thousand institutions failing. Commercial real estate values fell by half or more in many markets. It took years for full recovery. In the dot-com bust and subsequent recession, default rates again spiked to double digits. Several major telecommunications companies failed. Enron and WorldCom, among the largest corporate borrowers, collapsed in fraud. The high yield market suffered a brutal bear market.
In 2008 and 2009, the consequences were catastrophic. Default rates approached 15%. Major financial institutions failed, requiring government bailout. Credit markets froze completely. The economy experienced its worst recession since the Great Depression. I do not expect the coming turn to match 2008 in severity. The specific conditions that made that crisis so severe, the concentration of risk in the banking system, the opacity of mortgage-related securities, the interconnectedness of major institutions, are not as present today.
But I do expect significant stress. Default rates will likely rise substantially from current levels. Some financial institutions will face serious problems. Some asset categories will suffer severe losses. Some investors will be devastated. The debt cycle turns with the regularity of the seasons. Not at predictable intervals, but inevitably. And we are approaching another turn.
Let me discuss the policy response we are likely to see and how it might affect the cycle. When credit stress becomes acute, central banks typically respond by easing monetary policy. They cut interest rates. They provide liquidity to the banking system. They may restart quantitative easing or deploy other unconventional tools. The Federal Reserve has demonstrated repeatedly that it will act aggressively to prevent financial system collapse. In 2008, they deployed unprecedented measures. In March 2020, when COVID caused a sudden market seizure, they responded within days with massive intervention.
This creates a complicated dynamic. On one hand, aggressive policy response limits the downside. The Fed will not let the system collapse. They will provide a safety net. This reduces the risk of catastrophic outcomes. On the other hand, the expectation of policy support encourages more risk-taking. If investors believe the Fed will always bail them out, they take more risk than they otherwise would. This is the moral hazard problem. It leads to bigger bubbles and bigger eventual reckonings.
For investors, this means that the cycle may not reach the depths of true capitulation. The Fed will step in before maximum distress is reached. This limits the best opportunities, but also limits the worst losses. You need to be prepared to act when stress appears, not wait for maximum panic that may never come.
I also expect significant criticism of Federal Reserve policy in retrospect. Keeping rates at zero for 15 years created distortions that we are only now beginning to unwind. The reach for yield that zero rates forced on investors led to underpricing of risk throughout the system. The leverage that built up during the free money era would not have been possible at normal rates. This is not Monday morning quarterbacking. Many observers, myself included, warned during the zero rate era that distortions were building. But the warnings were dismissed because the immediate consequences seemed manageable and the alternative seemed worse.
Now we are dealing with the consequences. The debt that accumulated during the easy money era is stress-testing the system at higher rates. The refinancing challenges are real. The defaults are coming.
Let me also discuss how this cycle might differ from previous cycles. One important difference is the role of private credit. In previous cycles, most corporate debt was held in public markets or on bank balance sheets. Pricing was transparent. Distress was visible. Today, an enormous amount of credit has migrated to private markets. Direct lenders hold loans that are not marked to market. Valuations are whatever the managers say they are. Stress can build up invisibly until it suddenly erupts. This opacity could make the next credit event more surprising.
Problems that would have been apparent in public markets remain hidden in private portfolios. When the distress finally becomes visible, it may seem sudden even though it was building for months or years. Another difference is the structure of the financial system. Banks are better capitalized than before 2008. They face more restrictive regulation. They have less leverage and more liquidity. This should make the banking system more resilient. But it has also pushed risk-taking to less regulated corners of the financial system.
Private credit funds, business development companies, and other non-bank lenders have absorbed much of the risk that banks would have taken in previous eras. These entities do not have the same regulatory oversight or capitalization requirements. The risk has not disappeared. It has migrated, and the new holders of that risk may be less prepared to manage through a severe downturn.
Algorithmic trading amplifies price movements. Liquidity can disappear in minutes. This speed could make the acute phase of the credit turn sharper and more violent than historical precedents. What took weeks to unfold in previous cycles might happen in days. The time to react is compressed. Preparation in advance becomes even more important.
Finally, let me share how I am personally positioning for what I believe is coming. I am maintaining higher than normal liquidity. Cash and short-term treasury bills provide safety and optionality if opportunities emerge. I want to have capital to deploy. If they do not, I am earning reasonable returns while waiting.
I am avoiding the most credit-sensitive assets. I have minimal exposure to high yield bonds, leveraged loans, and commercial real estate. The risk-reward in these categories is unfavorable at current spreads and current cycle position. With equities, I am focused on quality companies with strong balance sheets, low leverage, durable competitive advantages. These companies will weather credit stress better than leveraged companies dependent on continued access to capital.
I am preparing our distressed investing capabilities. The opportunity set in distressed credit is growing. As more companies face stress, more situations emerge for analysis. I want to be ready to act when the best opportunities appear. And I am maintaining psychological equilibrium. Credit cycles are emotionally challenging. The late stage of expansion feels great, which is exactly when you should be cautious. The contraction phase feels terrible, which is exactly when opportunity is greatest. Keeping emotions in check is essential.
The debt cycle pattern that I have observed throughout my career is setting up again. The excess of the zero rate era created vulnerabilities. Higher rates are exposing those vulnerabilities. The consequences will unfold over the coming months and years. This is not a prediction of immediate crisis. The timing is inherently uncertain, but the pattern is clear. The direction is clear. And prepared investors will navigate this turn better than those who ignore the signs.
History does not repeat exactly, but it rhymes. And the rhyme I am hearing sounds very familiar. The debt cycle is turning. Make sure you are ready.
Let me elaborate further on some of the specific mechanisms through which debt cycles cause damage, because understanding these mechanisms helps you protect yourself. The first mechanism is the cash flow squeeze. When a company has debt, it must make interest payments and eventually repay principal. These are fixed obligations that must be met regardless of how the business is performing.
When times are good, meeting these obligations is easy. Cash flow exceeds debt service and there is plenty left over for reinvestment and shareholder returns. But when business conditions deteriorate, revenue falls and margins compress. Suddenly those fixed obligations become burdensome. Cash flow may still be positive but after paying interest there is nothing left. The company cannot invest in the business. It cannot weather extended periods of weakness. Every downturn becomes an existential threat.
This is why leverage amplifies both gains and losses. In good times, the fixed nature of debt obligations means that incremental revenue flows mostly to equity holders. In bad times, the fixed nature of debt obligations means that decremental revenue comes entirely from equity holders. Leverage magnifies the cycle. Companies that sailed through previous downturns with no difficulty may struggle in this one because they have more debt. The same revenue decline that was manageable before is crushing. This is particularly true for companies that levered up during the easy money era, which is a lot of companies.
The second mechanism is the refinancing wall. Most corporate debt has a finite maturity. The company borrows money for five or seven or 10 years, and then it must either repay or refinance. During normal times, refinancing is routine. The company takes out new debt to pay off old debt, often at better terms if conditions have improved.
But during credit crunches, refinancing becomes difficult or impossible. Lenders are not lending. Credit markets are closed. The company cannot roll over its debt, regardless of how willing it is to pay a higher rate. If the company cannot refinance and cannot repay from existing resources, it defaults.
The maturity wall I mentioned earlier is massive. Trillions of dollars of debt comes due in the next several years. Much of this debt was issued when rates were near zero and credit was abundant. Refinancing that debt in the current environment will be much more expensive at best and impossible at worst for the weakest borrowers. The companies most at risk are those with near-term maturities and limited ability to access capital markets. These companies need to act now to extend their maturities while they still can. Some will manage it. Others will wait too long and find themselves unable to refinance when their debt comes due.
The third mechanism is collateral deterioration. Many loans are secured by assets. Real estate loans are secured by property. Leveraged loans may be secured by company assets. As long as the collateral value exceeds the loan value, the lender has protection. But when asset values decline, collateral coverage deteriorates. Loans that were well secured become underwater. Lenders who expected to recover their principal through collateral seizure find that the collateral is worth less than the loan. Recovery rates decline, losses increase.
Commercial real estate is the clearest example right now. Loans were made based on valuations that assumed full occupancy and rising rents. Those valuations no longer hold. The collateral is worth far less than the loan balance. Even seizing the property will not make the lender whole. This collateral deterioration has knock-on effects throughout the financial system. Banks holding these loans must increase their reserves as collateral coverage declines. This reduces their capital and their capacity to lend. Securities backed by these loans decline in value, causing losses for investors who own them.
The fourth mechanism is contagion. Credit stress rarely stays contained. When one company defaults, its suppliers and customers are affected. When one lender suffers losses, it pulls back from lending to others. When one asset class declines, investors who own it sell other assets to meet margin calls or redemptions. We saw contagion vividly in 2008. What started as stress in subprime mortgages spread to prime mortgages, then to other consumer credit, then to corporate credit, then to the entire financial system. Each stage of the spread seemed to come out of nowhere, but in retrospect, the connections were obvious.
The contagion mechanism is unpredictable. You never know exactly how stress in one area will spread to others, but you know that it will spread. Interconnections in the financial system mean that problems rarely stay localized. Stress in one corner eventually affects the whole system.
Fifth is the liquidity spiral. When investors need to sell assets quickly, they often cannot get fair prices. The act of selling depresses prices, which may trigger more selling by others, which depresses prices further. Liquidity disappears precisely when it is most needed. This dynamic is particularly acute in less liquid markets: high yield bonds, leveraged loans, commercial real estate, private credit. These markets can absorb normal trading flows, but they cannot absorb waves of forced selling. Prices can gap down dramatically when too many sellers appear simultaneously.
The liquidity spiral is one of the most dangerous features of a credit crisis. Assets that seem liquid in normal times become impossible to sell. Prices fall far below intrinsic value because there are no buyers. Investors who need to raise cash are trapped. Understanding these mechanisms helps you identify where the risks are greatest. Assets that are most vulnerable to cash flow squeezes, refinancing challenges, collateral deterioration, contagion, and liquidity spirals are the ones most likely to suffer severe losses when the cycle turns.
Let me also discuss the psychological aspects of credit cycles, because human behavior is central to how these cycles unfold. During the expansion phase of the cycle, when credit is abundant and defaults are low, investors become increasingly confident. Success breeds confidence. Confidence breeds risk-taking. Risk-taking leads to more success, which breeds more confidence. The feedback loop is powerful.
This confidence manifests in several ways. Lenders extend credit to borrowers they would have rejected earlier in the cycle. Investors accept lower spreads for the same level of risk. Due diligence becomes perfunctory. Assumptions become optimistic. The consensus view is that the good times will continue. I have witnessed this pattern in every cycle of my career. Smart, experienced investors convince themselves that conditions have permanently improved. They find explanations for why traditional metrics no longer apply. They dismiss warnings as old-fashioned or out of touch. They keep reaching for yield and taking more risk.
Then the cycle turns. Suddenly, the confidence evaporates. The same investors who were reaching for risk become desperate to avoid it. Lending standards tighten dramatically. Spreads blow out. Assets that seemed perfectly safe are suddenly viewed with suspicion. The speed of the psychological shift is remarkable. What took years to build up can collapse in weeks or months. The confidence that supported elevated valuations disappears and prices adjust accordingly.
This psychological dynamic is why timing credit cycles is so difficult. The conditions for a turn can be present for extended periods before the actual turn occurs. Investors who position defensively too early suffer opportunity cost as the expansion continues. This makes it tempting to stay aggressive until the turn is obvious, but by then it is too late. The solution is not to try to time the turn precisely. The solution is to maintain discipline throughout the cycle.
To resist the temptation to reach for yield when spreads are tight, to maintain standards when others are abandoning them, to keep dry powder even when deploying it into risky assets seems more attractive. This discipline is extraordinarily difficult to maintain. There is immense pressure to match the returns of more aggressive investors during the late stages of expansion. Career risk for professional investors means that being early with defensive positioning can cost you your job. The institutional pressures all favor staying aggressive until the turn is undeniable.
Individual investors have an advantage here. You do not have to justify your positioning to a boss or a board. You can be defensive even when it is unfashionable. You can maintain discipline without worrying about short-term relative performance. Use that advantage. Position your portfolio for the cycle turn that is coming, even if you cannot know exactly when it will arrive.
Let me provide some specific indicators that I watch to assess the credit cycle. Default rates are the most obvious indicator but they are lagging. By the time default rates spike, the damage is already being done. Still the direction of default rates matters. If they are rising, conditions are deteriorating. Right now, they are rising from very low levels, which is consistent with the early stage of a cycle turn.
Credit spreads are a more forward-looking indicator. Spreads represent the extra yield investors demand for taking credit risk. When spreads are tight, investors are complacent. When spreads widen, investors are becoming concerned. Currently, spreads are relatively tight, suggesting that most investors have not yet positioned for deterioration.
Lending standards are crucial. Surveys of bank lending officers provide insight into how standards are changing. When banks tighten standards, credit becomes less available, which causes further deterioration. Currently, banks are tightening standards, particularly for commercial real estate.
Distressed ratios track the percentage of high yield bonds trading at spreads that indicate high default probability. This measures how many companies the market sees as troubled. The distressed ratio has been rising, indicating growing concern about credit quality. Interest coverage ratios measure how easily companies can service their debt from operating income. When these ratios decline, more companies are at risk of being unable to meet their obligations. Across the leveraged loan universe, interest coverage has declined substantially as rates have risen.
I watch all of these indicators, but I do not rely on any single one. The picture emerges from the combination. And right now the combination is telling me that we are in the late stage of the credit cycle with meaningful stress building.
Let me close with some thoughts on how long cycles typically last and what that might tell us about timing. Credit cycles do not have fixed durations. The expansion that began in 2009 has lasted 15 years, far longer than typical historical cycles. The extended duration reflects the extraordinary policy response to the financial crisis. With interest rates held at zero for far longer than ever before, this extended expansion has allowed more excess to build. More debt has accumulated. More risk has been taken. More companies have borrowed amounts they would not have been able to service in a normal rate environment.
When expansions run long and excesses accumulate, the subsequent contractions tend to be more severe. The bigger the bubble, the bigger the bust. The more leverage in the system, the more violent the deleveraging. I do not know exactly when the acute phase of the contraction will arrive. It could be triggered by a recession, by a major default, by a geopolitical shock, by something no one is anticipating. The trigger is inherently unpredictable, but I am confident that it will arrive.
Credit cycles have turned with remarkable regularity throughout financial history. The conditions for a turn are clearly present. The excess of the easy money era created vulnerabilities that are now being exposed. Some investors will be caught by surprise. They will have positioned as if the good times would continue indefinitely. They will suffer severe losses when the turn comes.
Other investors will be prepared. They will have maintained liquidity when others were fully invested. They will have focused on quality when others were reaching for yield. They will have kept dry powder for opportunities that emerge during stress. The difference in outcomes between these two groups will be enormous. The prepared investors will not only avoid the worst losses, they will be positioned to profit from the opportunities that stress creates. Their wealth will compound through the cycle rather than being destroyed by it.
Which group will you be in? The choice is yours to make. The time to make it is now, before the cycle completes its turn. The debt cycle pattern that has repeated throughout history is setting up again. The signs are clear for those willing to see them. The only question is whether you will heed them. The cycle is turning. Prepare accordingly.
