The misunderstood consumer

| December 18, 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. This material does not constitute research.

As the market looks toward next year and keeps tightening spreads on almost all credits, the distinctions between credits start to matter more. Somewhere between the prospects for credit generally and for individual bonds sits the choice between consumer or corporate credit. Consumers are coming out of pandemic on average stronger than before, corporations are coming out weaker. Spreads do not seem to reflect that.

Spreads on one of the larger and most frequently issued forms of consumer debt, prime jumbo MBS, stand wider currently than before pandemic. Newly issued ‘AA’ through ‘BBB’ MBS traded in January between 44 bp and 95 bp wider than similarly rated corporate debt (Exhibit 1). Those same newly issued classes of MBS have traded in recent months between 115 bp and 125 bp wider than similarly rated corporate debt. Assuming roughly stable differences in prepayment risk, duration, liquidity and technicals between the new MBS and the corporate benchmarks, the shift in spread should largely reflect a shift in relative credit risk. The wider spreads on MBS credit do not square well with emerging fundamentals.

Spreads on prime and subprime auto ABS between ‘AA’ and ‘BBB’ have broadly returned to early 2020 levels. Demand for cars and trucks has gone up during pandemic as more consumers have traded short flights for longer drives and public transportation for private vehicles. Spreads on private student loan ABS remain substantially wider than early 2020 levels reflecting substantial forbearance on student debt and uncertainty about repayment

Exhibit 1: Wider spreads between similarly rated MBS and corporate debt

Note: Data reflect RMBS spreads to the WAL Treasury on prime jumbo new issue transactions and on the ICE BoA US Corporate OAS Index for each rating category. The corporate spreads reflect the arithmetic average for the indicated month.
Source: Amherst Pierpont Securities, ICE BoA US Corporate Indices from the Federal Reserve Bank of St. Louis.

A stronger consumer balance sheet

Despite the relative direction of spreads, consumers are coming out of pandemic with a much stronger average balance sheet than before. Household net worth in the first nine months of this year went up by more than $5 trillion. That includes an added $2 trillion in cash, checking and savings accounts, more than $1 trillion in home equity and more than $1 trillion in gains on investments. That is not all evenly distributed, of course, since the most recent figures from the Pew Research Center show only half of all US families have exposure to the stock market. And cash holdings heavily reflect benefits of the CARES Act and elevated household savings. The gain nevertheless leaves household net worth up for the year by 4.4% and at a record high.

The gain this year comes after more than a decade of steady deleveraging by consumers. Total mortgage and other consumer debt stood in 2008 at a peak of 90.8% of GDP; it finished September at 70.5%. The mix of consumer debt has changed. Residential mortgages over the same period have dropped from 73% of GDP to close September at 51%. Credit card, auto and most other forms of debt have held a fairly steady share. Student debt has roughly doubled from 4% of GDP in 2006 to finish September at more than 8% of GDP.

A weaker corporate balance sheet

Corporations are coming out of pandemic more leveraged. Long-term corporate debt and loans stood at a March 2009 mark of 45.3% of GDP and finished September at 51.5%. Looking at corporate balance sheets, debt and loans as a share of corporate net worth has run from at 2009 mark of around 45% to a recent mark above 68%. A New York Fed study of companies emerging from the 2008 financial crisis shows that higher leverage put a drag on growth for years whether measured by assets, number of employees or capital expenditures.

As with the gains on the consumer balance sheet, the rise in corporate leverage is not equally distributed. Companies in the travel, leisure, energy and services areas, among others, have seen leverage grow faster than other sectors. Nevertheless, median investment grade and high yield leverage has still gone up in 2020 as companies drew down lines of credit and issued debt to stockpile cash. Even through faster growth in 2021 should lift prospects for that debt, companies may grow more slowly than the might without the debt overhang.

Allocate toward the stronger forms of consumer debt

Some forms of consumer debt should trade at tighter spreads today than at the start of 2020, at least relative to similarly rated corporate benchmarks. Borrowers backing prime jumbo private MBS in particular have likely seen income, cash positions, investment assets and home equity all rise. Borrowers backing reperforming loan MBS may have less exposure to investment assets but still have likely seen cash positions and home equity rise. The relative fundamentals on these consumer balance sheets relative to corporate debt have strengthened through 2020.

Adding exposure to the consumer balance sheet at wide spreads looks like a good way to add return to what should be a banner year for credit. Fiscal stimulus, an accommodative Fed and a rebound from pandemic should lift all credit. But the consumer balance sheet should trade to progressively tighter spreads.

* * *

The view in rates

The Treasury yield curve has finished its most recent session with 2s10s at 83 bp, the high point for the year, and 5s30s at 131 bp, just below the high point for the year. The steepening largely reflects rising inflation expectations. The spread between 10-year notes and TIPS shows inflation expectations at 197 bp, also the high point for the year, with real yields showing significant weakness and dropping below -100 bp. Prospects of fiscal stimulus, pandemic recovery through 2021 and a very easy Fed all should fuel further steepening. Heavy Treasury supply is adding steady pressure, too. Implied interest rate volatility remains low, helped by high levels of market liquidity and a Fed pledged to keep rates low and QE running until it sees “substantial progress” toward economic recovery.

The view in spreads

Both MBS and corporate spreads are approaching their tightest levels of the year with plenty of room to tighten further. Tremendous net Treasury supply is creating a surplus of the riskless benchmark while QE absorbs MBS, the relatively riskless spread asset, at least regarding credit. Beyond the influence of net Treasury supply, fiscal stimulus, pandemic recovery and Fed policy should also keep spreads steadily tighter through 2021. Weaker credits should outperform stronger credits, with high yield topping investment grade debt and both topping safe assets such as agency MBS and Treasury debt. Consumer credit should outperform corporate credit.

The view in credit

Consumers in aggregate are coming out of 2020 with a $5 trillion gain in net worth. Aggregate savings are up, home values are up and investment portfolios are up. Consumers have not added much debt. Although there is an underlying distribution of haves and have nots, the aggregate consumer balance sheet is strong. Corporate balance sheets have taken on substantial amounts of debt and will need earnings to rebound for either debt-to-EBITDA or EBITDA-to-interest-expense to drop back to better levels. Credit in the next few months could see some volatility as Covid begins forcing shutdown of some economic activity and distribution of vaccines potentially hits some logistical potholes. But distribution and vaccine uptake through next year should put a floor on fundamental risk with businesses and households most affected by pandemic—personal services, restaurants, leisure and entertainment, travel and hotels—bouncing back the most.

john.killian@santander.us 1 (646) 776-7714

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