The Big Idea

The rich get richer

| December 1, 2023

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.

The Fed meeting at the start of November and its picture of balanced policy has set off a grab across debt markets for risk, interest rate and otherwise. And although absolute spreads have moved tighter across risk assets, the picture of relative value has stayed surprisingly consistent. MBS and structured credit trade relatively wide, corporate credit trades relatively tight. Only investment grade corporate credit has richened faster than its debt market peers. In debt as in life, the rich have gotten richer.

A picture of fixed income relative value

The current relative value picture looks a lot like the one at the beginning of September, the last time I ran the numbers across fixed income (Exhibit 1). Looking at option-adjusted spread on each sector as a percentile of its 5-year history, MBS, CMBS and ABS all trade wide. The current OAS on each of these sectors stands at least at the 70th percentile of its 5-year distribution, meaning 70% of the time or more the asset has traded tighter. CLOs and investment grade and high yield corporate credit, on the other hand, all trade tighter, with most at the 40th percentile or less.

Exhibit 1: MBS and structured credit trade wide, corporate credit trades tight

Source: Bloomberg, Santander US Capital Markets

The other notable result from the snapshot of spreads from September through November is a handful of sectors that have tightened much faster than everything else—investment grade utilities, ‘A’ CLOs, the entire investment grade index and investment grade industrials. Not only has credit in general stayed relatively tight, but investment grade credit has tightened faster than other parts of fixed income.

Diagnosing spread differences

Something is keeping securitized products wide and corporate credit tight, and the usual suspects would be either trends in fundamental risk or in the balance of supply and demand in each sector. The most likely explanation looks like differences in supply-and-demand balance between securitized products and corporate credit, with securitized products at risk of ongoing reduction in Fed and bank balances while technicals in corporate credit seem more balanced:

  • Securitized products supply-and-demand. The technicals for agency MBS and CMBS remain daunting. The Fed and banks have dominated demand in these products for years but have reduced exposure materially in 2022 and 2023 and should continue through 2024 and possibly beyond. The Fed plays no role in private CMBS and ABS while banks play a limited role, so fundamentals in these sectors may be the better explanation for wide spreads.
  • Corporate credit supply-and-demand. US and foreign insurers and other foreign portfolios are the largest buyers of corporate credit, and insurance balance sheets remain healthy sources of demand. Since both corporate debt issuance and insurance premiums should roughly track GDP, there is good reason to expect supply and demand to remain in balance.

Differences in fundamental risk across securitized products and corporate credit offer a more mixed picture:

  • Securitized products fundamentals. At least within the agency MBS and CMBS sectors, where credit is less of an issue than convexity, it is hard to point to fundamentals that would justify spreads at the wide end of its 5-year distribution. In fact, the stronger case might argue the opposite for MBS since most of that market trades at a deep discount to par and has much more stable cash flows than most times in the last five years. In ABS, there is increasing concern over rising delinquencies in cards and autos and likely pressure over the next year on consumer income. In private CMBS, there is legitimate fundamental reason for wide spreads due to exposure to office properties and increasing concern over multifamily.
  • Corporate credit fundamentals. Corporate credit fundamentals are broadly good but not so good to justify trading well inside the median of its 5-year distribution. Earnings growth is slowing, rates should put pressure on corporate interest expense if they stay high for a long time, liquidity across lending markets should continue to decline with tight Fed policy and economic growth is widely expected to slow. The next year could test credit fundamentals.

Although technicals for MBS are daunting, credit faces more fundamental challenges. In MBS, relative value looks best in the most liquid and convex parts of the market and in allocations with relatively low spread duration. In credit, relative value looks best in liquid, higher quality names and, again, in allocations with low spread duration. The flexibility should help investors navigate next year.

* * *

The view in rates

Fed funds futures not only put the chance of a hike at the December 13 FOMC at basically zero but have priced a first cut for March and a cumulative five cuts by December. The Fed has entered the quiet period ahead of the December meeting, so it will have nothing to say before then to shape market expectations. The risk in the funds futures is that inflation proves more persistent and that the Fed holds rates high into September before any cuts.

Other key market levels:

  • Fed RRP balances closed Friday at $768 billion as the facility continues to decline, down $369 billion through November. Money market funds continue to move cash out of the RRP and into higher-yielding Treasury bills.
  • Setting on 3-month term SOFR traded Friday at 537 bp, roughly unchanged since late August
  • Further out the curve, the 2-year note closed Friday at 4.54%, down 30 bp since November 10. Given the likely Fed path, fair value on the 2-year note is above 5.00%. The 10-year note closed at 4.20%, down 45 bp since November 10.
  • The Treasury yield curve closed Friday afternoon with 2s10s at -34, steeper by 7 bp since November 10. The 5s30s closed Friday at 26 bp, steeper by 18 bp.
  • Breakeven 10-year inflation traded Friday at 223 bp, down 9 bp since November 10. The 10-year real rate finished the week at 198 bp, down 34 bp since November 10.

The view in spreads

The market has rapidly priced in Fed easing and tightened spreads on risk assets, but that seems premature. Policy is likely to remain relatively tight through the first half of the year, and resulting lower liquidity is likely to offset stability in policy and keep volatility elevated. Spreads should widen from current levels and remain volatile. The Bloomberg investment grade cash corporate bond index OAS closed Friday at 139 bp, tighter by 16 bp since November 10. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 160 bp, tighter by13 bp. Par 30-year MBS TOAS closed Friday at 44 bp, tighter by 23 bp. Both nominal and option-adjusted spreads on MBS look rich. Fair value in MBS is likely closer to 70 bp, so the subsequent widening toward 70 bp looks reasonable.

The view in credit

Most investment grade corporate and most consumer balance sheets look relatively well protected against higher interest rates, but a lot will depend on how long rates remain high. Fixed-rate funding largely blunts the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. Less than 7% of investment grade debt matures in the next year, so those balance sheets have some time. But other parts of the market funded with floating debt continue to look vulnerable. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B-‘ loans show clear signs of cash burn. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers and younger households borrowing on credit cards, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans should add to consumer credit pressure.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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