The shifting shape of consumer and corporate credit
admin | May 8, 2020
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.
Relative value continues to shift in consumer and corporate credit. On the consumer balance sheet, unemployment has just started driving forbearance and delinquency across a wide range of debt with the clearest opportunity in their impact on mortgage prepayments. On the corporate balance sheet, uncertainty about earnings has arguably never been higher, making names with good liquidity the most likely safe harbor.
Eroding consumer credit but safe harbor in sectors of MBS
Various forms of deferred payment and delinquency have started spreading across consumer debt. Mortgage originators began offering forbearance in March, and through the end of April Black Knight reports 7.3% of outstanding loans in forbearance. Originators of auto loans and leases have started offering deferred payments, too, with the rate of outstanding loans in deferral at the end of March ranging between 4% and 7% depending on borrower credit and almost undoubtedly heading higher in April.
Borrowers in deferral or forbearance gain time to bridge temporary loss of income but lose financial flexibility, and that applies to mortgage refinancing. Loans in forbearance cannot refinance. An expected 10% of Fannie Mae and Freddie Mac loans look likely to be in forbearance at some point in the next year. The share rises to 20% in Ginnie Mae, with the FHA loans backing Ginnie Mae hitting 30%. Elsewhere in this issue, Brian Landy details emerging differences in the rate of forbearance across mortgage loan-to-value, borrower credit score, loan size, geography and other attributes.
The value of MBS cash flows rises as forbearance dampens prepayments. Ginnie Mae MBS consequently look undervalued as do a range of conventional specified pools—if, as it likely, Fannie Mae and Freddie Mac end up offering attractive deferral plans once forbearance ends.
Deferral only works if it’s temporary. Persistent deferral or forbearance typically compounds consumers’ debt burden and raises the likelihood of eventual default. In the markets for Fannie Mae and Freddie Mac credit risk transfers and for legacy or new private MBS, newer deals often end up looking riskier than older deals where borrowers have built up substantial equity through home price appreciation. Unemployed borrowers will generally sell before defaulting and losing their equity. Seasoned exposures to residential credit look like safer harbors.
Outside of residential real estate, no other consumer assets offer collateral where the borrower has substantial equity. The only protection beyond securitization structure is the borrowers’ ability and willingness to pay. And borrowers are in flux.
Eroding corporate credit but safe harbor in liquidity
Corporate credit also continues to erode. Among issuers in the institutional leveraged loan market, where liquidity is most stressed, 27% of issuers have either been downgraded by S&P since early March or put on watch for downgrade.
Corporate earnings have rarely been less certain. A new Fed study finds that the share of public firms drawing down lines of credit in the first quarter hit 17%, the share cutting dividends hit 27% and the share cutting investment hit 42%. All of these figures are more than 6.5 standard deviations above their historic averages. All of these figures point to balance sheets storing up cash to bridge potential shortfalls in revenue for as long as possible.
Balance sheets with cash have optionality that should reward debt holders. Some business models will emerge from social distancing and other responses to coronavirus intact and the cash will bridge the gap. Others will emerge into markets where the model is no longer viable, and the cash will buy time to pivot if possible. Elsewhere in this issue, Meredith Contente and Dan Bruzzo highlight names that offer good spread for each turn of net leverage.
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The view in rates
The rates market remains in the hands of the Fed, and the Fed has convinced the market it will keep rates low for years. Futures and OIS curves continue to imply policy rates near the zero-bound into 2023. QE along with other monetary and fiscal interventions of historic magnitude should keep concerns about inflation on the market agenda and keep the yield curve biased to steepen. The current 0.68% rate on 10-year Treasury debt implies an average real rate of -43 bp and inflation of 112 bp. Implied inflation has run slightly above 100 bp since mid-March.
The view in spreads
Spreads markets with Fed or fiscal support should continue tightening, and the impact of scarcity, broad liquidity, falling default and prepayment premia should tighten other debt sectors, too. Those markets now include Treasury and agency MBS, agency CMBS and investment grade corporate debt, a wide range of ABS, legacy CMBS and ‘AAA’ static CLOs.
The view in credit
The immediate risk in credit is from companies with high fixed costs and a sharp drop in revenue from current efforts to avoid coronavirus infection. Rating agencies have started downgrading companies and related structured products, CLOs in particular, at a record pace. Companies with the highest leverage are first in line. Until the arrival of pandemic, the consumer balance sheet has been extremely strong. The coming sharp rise in unemployment should change that, although the CARES Act could help cushion the blow. Nevertheless, delinquencies and defaults on mortgage and consumer loans have already started to climb quickly.