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Move up in quality in consumer finance

| August 2, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Bank and financial credits have been leading the charge tighter in investment grade (IG) spreads in recent weeks. With investors seeking out lower-rated credits, some of the more active trading has been taking place among the card lenders Capital One Financial (COF: Baa1/BBB/A-), Discover Financial (DFS: Baa3/BBB-/BBB+), Synchrony (SYF: BBB-/BBB-), and non-IG consumer finance credit, Ally Financial (ALLY: Ba2/BB+/BB+) – which despite lower ratings, trades in relative lock-step with the rest of the IG issuers.

Spreads for intermediate paper of COF and DFS have compressed as much as -100 bps at certain points on the curve from their January 5, 2019 wides when unsecured 5-year holdco notes were briefly trading closer to 180-200 level range. Even more impressive has been the performance in SYF, which is currently trading at a roughly 25 to 35 bp pick (on average) to COF/DFS curves, from the wides when bonds were trading in the mid-to-high +300s range, or as much as 150 to 200 bp wide of their IG peers. SYF issued twice over the interim (March $1.25 billion, July $750), which aided price discovery and visibility in the credit.

Exhibit 1: Current spreads of consumer finance lenders COF, DFS, SYF and ALLY

Note: Structures include holdco, senior and sub bank paper. Source: Bloomberg/TRACE indications, Amherst Pierpont Securities.

Relative Value

At current valuation, investors should be taking some of their SYF risk off the table, and seeking opportunities to trade up in quality to either COF or DFS. Over the near-term COF and DFS are likely to continue trading in a close band, but investors with a longer-term horizon would be better suited to own more COF over DFS. Short-term volatility and a persistently been negative bias toward COF should eventually be outweighed by their higher credit quality, and resolution of some of their nearer-term uncertainties.

Exhibit 2: Spreads at the recent wides, January 5, 2019

Note: Structures include holdco, senior and sub bank paper. Source: Bloomberg/TRACE indications, Amherst Pierpont Securities.

Credit quality – comparing COF, DFS and SYF in 3 key stats

There are plenty of differences between the three lenders, particularly for SYF, which uniquely has core operations in private label branded cards and payment processing services. Nevertheless, looking at key credit fundamentals can give us some longer-term insights about the differences in the names. The first credit metric to highlight is margin, specifically net interest margin (NIM) and yield/cost spread. With rates pushing even lower and yield curves flatter, the attractiveness of credit card issuers’ higher margins has come into focus for investors. Using regulatory financials as of 1Q19, COF had a NIM of 6.86% and a yield/cost of 6.57%, far higher than more traditional BBB regional banking peers, which typically run in the 3-4% range and as low as mid-2%. DFS’ NIM was 8.90% and yield/cost 8.57%. SYF’s NIM as of 1Q19 was 12.71% and yield/cost 12.23%. Using reported numbers of 2Q19, SYF had a NIM of 16.07% (not regulatory figures), DFS reported NIM of 8.58%, and COF reported NIM of 6.90%. Higher-risk card/consumer lenders will typically report significantly higher margins, and all three have seen margins expand over the past several years, as they loosened standards and began offering credit to weaker borrowers.

The second credit metric is funding stability by comparing the loan/deposit (%) ratio for each of the lenders as of last regulatory filing: SYF – 137%, DFS – 129% and COF – at 95%. This means that only COF can fully fund their loan book utilizing stable deposits, and that the other two are far more reliant on wholesale funding. This is a big component of the high-BBB vs low-BBB ratings of COF vs DFS/SYF. In fact, despite a fairly big footprint in the public debt markets, COF’s usage of wholesale funding is only currently about 23% (of liabilities), with less than 15% attributed to shorter-term, higher risk sources. Comparatively, DFS is 54% reliant on wholesale funding, with 40% attributed to less stable short-term sources, such as money markets. SYF is 40% reliant on wholesale funding, with about 31% in short-term. This puts COF in a much different risk category than either of the other two – albeit those concerns are being mitigated by the persistence of the low-rate environment, which is making non-deposit funding cheap and readily available.

Exhibit 3: Relationships at previous tights, October 5, 2018. More spread for SYF while COF and CFS traded in close context.

Note: Structures include holdco, senior and sub paper. Source: Bloomberg/TRACE indications, Amherst Pierpont Securities

The last credit metric for comparison is the Texas ratio (%), which measures adjusted non-performing assets (NPA) plus 90-day past-due loans as a percentage of total common equity and loan loss reserves. This provides a quick snapshot of a lender’s ability to quickly fund its delinquent loans with available capital. The measure is a good proxy for all-in loan book risk, and typically for regional banks results anywhere below <20-25% are viewed as being highly manageable in most cases. COF’s Texas ratio is 8.9%, DFS’ is 26.7% and SYF’s is 16.2% — which again demonstrates that COF is a cut above the other peers, and that DFS is slightly outside the comfort zone for the IG bank sector.

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