The Big Idea
Bullish on consumer credit
Steven Abrahams | May 7, 2021
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.
Consumers overall have come through the worst of the pandemic with the strongest balance sheet in decades and with strong prospects ahead. Income should keep rising with employment. Net worth should keep rising with home prices. The market does not yet seem to price that in. Consumer credit has lagged the tightening in corporate debt, adding to the case for relative value on the consumer side.
Spreads have not priced to relatively stronger consumer fundamentals
Freddie Mac credit risk transfers make for a consistent and relatively liquid pricing benchmark for deep consumer credit, and that market has lagged the tightening in corporate debt. The Freddie Mac securities carry leveraged risk of mortgage default and loss along with prepayment risk, and new issue spreads today stand wider than pre-pandemic marks. Spreads on comparable ‘BBB’, ‘BB’ and ‘B’ corporate debt have come closer to full recovery, and corporate debt consequently has closed the gap to the risk transfers (Exhibit 1). This does not reflect the recent evolution of consumer and corporate balance sheets.
Exhibit 1: Corporate spreads have tightened to consumer benchmarks despite relatively stronger consumer balance sheets: ‘BBB’ corporate credit has tightened to ‘BBB’ mortgage benchmarks
‘BB’ corporate credit has tightened to ‘BB’ mortgage benchmarks
‘B’ corporate credit has tightened to ‘B’ mortgage benchmarks
A much stronger consumer
The consumer balance sheet last year improved to levels not seen in decades. Assets jumped $12.8 trillion off gains in equities ($3.8 trillion), cash in the bank ($2.8 trillion) and real estate ($2.1 trillion). Liabilities went up $650 billion. The windfall pushed total net worth as a percent of disposable personal income to 755%, the highest on record (Exhibit 1). Equity prices, federal cash transfers to households and residential real estate values have continued to rise since the end of the year, adding to the consumer balance sheet.
Income for consumers also improved. Disposable personal income per capita hit a record at the end of last year, and debt service as a percent of disposable income ran well below average (Exhibit 3). The decline in unemployment this year from 6.7% to 6.1% has continued to lift household income.
Exhibit 3: Disposable personal income per capital has hit a record…
And debt service as a percent of DPI continues to run below average
Consumers have good prospects for continued growth in home equity and income. Rising home prices have clearly reflected a lack of housing supply, with fewer homeowners willing to put property on the market and relocate in the middle of pandemic. But prices also reflect rising demand as more households plan for the possibility of working from home. The net result is that home vacancies and the supply of homes available for sale in months have dropped to the lowest level since the 1970s. Beyond immediate imbalances, demographics and homeownership trends argue that steady demand for housing will outlast pandemic, and homebuilders will likely be hard-pressed to find the land and workers needed to easily meet demand. On the income side, the new Fed emphasis on targeting low unemployment along with government efforts to support low-income households should keep overall consumer income rising.
It is important to recognize that a segment of consumers missed the lift in net worth from equities and real estate simply because the households did not have material exposure. Many of these same households saw healthy income from government transfers, and the share of consumers with subprime credit scores dropped sharply to the lowest mark in at least 15 years . Credit in this sector will depend on whether pandemic support programs get replaced by employment, new forms of government support or a combination.
A more mixed picture for corporate balance sheets
The corporate balance sheet is more mixed than the consumer. It has come out of 2020 with higher leverage overall, which in part reflects the rising share of outstanding debt rated ‘BBB’ (Exhibit 4). But leverage has also gone up within rating categories. The leverage is mitigated by more cash on the balance sheet, lower interest costs and prospective gains from good economic growth. Still, the corporate balance sheet comes out of 2020 more indebted and exposed to rising interest costs.
Exhibit 4: Corporate leverage continued to rise through 2020 overall…
And within each rating category
Corporations also finished last year with lower earnings. EBITDA year-over-year growth finished 2019 at 3%. After growing 2% year-over-year in the first quarter last year, it fell in the succeeding quarters by -2%, -1% and -0.04% (Exhibit 5). Higher leverage will put a premium on steady EBITDA growth to pay down debt and give the balance sheet strength and flexibility.
Exhibit 5: Corporate EBITDA growth went negative from Apr-Dec last year
It is worth noting that the equity market still sees the corporate balance sheet as capable of servicing the higher debt load and still delivering earnings growth to shareholders. Business debt as a percentage of equity market value finished last year close to the lowest level on record (Exhibit 6).
Exhibit 6: Debt as a share of equity value implies a manageable debt load
Consumer sector matters
The strongest part of the consumer debt market will likely be the sectors serving households with equity and real estate exposure and with the lowest rates of unemployment. That broadly describes the market served by Fannie Mae and Freddie Mac—at least the part with loan-to-value ratios of 80% or below—along with sectors served by issuers of prime jumbo RMBS. The credit exposures built into the agencies’ credit risk transfers and into mezzanine and subordinate classes of prime jumbo private securitizations have the most to gain from continuing consumer strength. The lower in the capital structure, the more leveraged the return.
Other sectors of RMBS stand to gain, such as non-QM RMBS. But these sectors serve heavy concentrations of investors in residential real estate and owners of smaller businesses. The tenants in the investors’ properties may be more subject to fluctuating income over time and do not have homeowner equity. Owners of smaller businesses will have to navigate the aftermath of pandemic, including shifts in consumer preferences for goods and services and for the businesses that provide them. The New York Fed recently described the challenges for small businesses hoping to reopen.
Many of the households in the best condition have enough liquidity to limit their needs for other debt. Investors may be able to get some exposure through auto loans and leases secured by luxury vehicles. Opportunities in credit cards and student loans and other ABS are very limited.
Debt investors could also play the consumer balance sheet through the corporate market, overweighting debt issued by consumer lenders, for instance, or overweighting consumer cyclicals. But the steady rise in equities and the tightening of corporate spreads suggests much of the anticipated good news is already baked in.
It is surprising that consumer credit spreads have not tightened faster than comparable corporate benchmarks. The case for consumer credit seems strong. The case for corporate credit seems more mixed. At current spreads, the better relative value goes to the consumer.
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The view in rates
Effective fed funds slipped to 5 bp to start the most recent week with SOFR pinned at 1 bp and the 30-day average of SOFR at 1 bp. Credit spreads in the money markets hover near their 5-year lows. All point to cash weighing heavily in the front end. Balances at institutional government money market funds have risen by $295 billion so far this year, and other sources of cash have contributed to the rush into repo. Funding rates look likely to stay very low for very long.
The 10-year note has finished the most recent session at 1.58%, down 5 bp from a week before. Rates have become a battle between rising inflation expectations and falling real rates. Inflation expectations continue to rise with 5-year breakevens up 10 bp on the week to 269 bp, 10-year breakevens moving up 9 bp to 250 bp and 5-year breakevens 5-years forward up 7 bp to 232 bp. Real rates, meanwhile, continue to fall suggesting some doubts in the rates markets about long-term growth and its ability to absorb an expected overhang of liquidity.
The Treasury yield curve has finished its most recent session with 2s10s at 146 bp, roughly flat to mid-March. The 5s30s curve has finished at 145 bp, flatter by nearly 20 bp since mid-March. Although 10-year and longer rates have potential to rise back toward 2.0% if growth comes in well above consensus, most of the action should come on the shorter end of the curve as the market reprices the Fed’s response to growth, inflation and employment rather than the fundamentals themselves.
The view in spreads
Fed buying, a strengthening bid from banks and a slowing of new MBS origination are coming together as a recipe for tighter spreads. MBS spreads should keep tightening, and the dollar roll in MBS special. The nominal spread between par 30-year MBS and the interpolated 7.5-year Treasury yield closed recently at 63 bp, just 3 bp off the tightest level in MBS market history.
In credit, support from insurers and money managers should keep spreads tightening. Investment grade spreads have generally outstripped high yield on the back of bids from insurers and money managers, but high yield should get its due. 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. The consumer balance sheets has come out of 2020 stronger than ever—at least on average—and consumer credit should outperform corporate credit.
The big risk to spreads should come when the Fed starts making noise about approaching its targets for employment and inflation and tapering asset purchases. Keep those antennae tuned.
The view in credit
By the end of 2021, US GDP could be above levels projected before Covid for late 2021. That would represent one of the fastest and strongest rebounds from recession in US history. Consumers should continue to build strength. Aggregate savings are up, home values are up and investment portfolios are up. Consumers have not added much debt. Corporate balance sheets have taken on more leverage, although mitigated by strong cash balances and low interest costs. Corporations will need earnings to rebound for either debt-to-EBITDA or EBITDA-to-interest-expense to drop back to better levels. But strong economic growth in 2021 and 2022 should lift most EBITDA and continue easing credit concerns. Eventually, rising interest expense should compete with EBITDA growth. But not yet.