The Big Idea

Strong consumer, wide spreads

| February 2, 2024

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.

Household balance sheets today look surprisingly strong despite pandemic and the Fed’s nearly 2-year and 525 bp campaign to slow the economy and rein in inflation. Net worth and real disposable income have improved, household debt coverage is good, and delinquencies show no clear signs of distress. Consumer debt nevertheless trades at wider spreads than average and much wider than comparable corporate debt. Credit has momentum, but consumer exposures should do better than most.

Stronger-than-average households

Household balance sheets today show surprising strength on measures of net worth, income and ability to service debt:

  • Absolute net worth and net worth as a multiple of GDP is at or near the highest levels in at least 30 years and tops pre-Covid marks across income tiers
  • The net worth bump partly reflects gains in real estate equity across income tiers, giving households valuable collateral for borrowing as a buffer to unemployment or other economic shock
  • Real disposable income has moved above its long-term trend and household debt coverage looks good, suggesting wage and other income gains have blunted the impact of inflation on spending power, and
  • Consumer delinquencies still show no clear signs of distress

Those net worth and income numbers argue that diversified household and consumer credit exposures, all else equal, should trade at tighter spreads than they did for long stretches before Covid. But that is not the case.

Wider-than-average spreads

Most household or consumer debt today trades at wider spreads than most of the last five years, unlike the bulk of fixed income, which trades at tighter spreads. To see this, it helps to look at the current spread on an asset as a percentile of its 5-year range, where 100% means the widest spread in the last five years, 50% means the median spread, and 0% means the tightest.

The average investment grade asset-backed security—auto loans, credit cards and other ABS with 2.6-year duration and strong weighted rating of ‘AAA/AA+’—trades at a 62 bp OAS. That is at the 61st percentile, wider than the OAS in 61% of all sessions in the last five years (Exhibit 1).  Meanwhile the average investment grade corporate debt—with a 6.9-year duration and a weaker weighted rating of ‘A-/BBB+’— trades at a 96 bp OAS. That is at the 17th percentile, wider than only 17% of sessions in the last five years. The incremental spread compensation for going from average ABS to average corporate risk looks skinny.

Exhibit 1: ABS OAS trades wide to the 5Y median, corporate OAS trades tight

Source: Bloomberg, Santander US Capital Markets

In fact, most major sectors of fixed income today trade tight. Investment grade (17th percentile), high yield (21st percentile) and emerging markets sovereign debt (29th percentile) trade at the tight end of their 5-year spread range (Exhibit 2). Agency MBS (51st percentile), Ginnie Mae 30-year MBS (59th percentile) and conventional 30-year MBS (49th percentile) trade around the middle of their range. And ABS and CMBS trade at the moderately wide end of their range (Exhibit 2).

Exhibit 2: ABS trades at the wider end of its 5Y spread range than credit, MBS

Note: A 100% percentile rank would indicate the widest spread in 5Y and a 0% rank would represent the tightest spread. All spreads based on the corresponding Bloomberg market index.
Source: Bloomberg, Santander US Capital Markets

Wider nominal spreads in ABS from ‘AAA’ through ‘BBB’

The tighter OAS on the average ABS and the wider OAS on the average investment grade corporate bond hides the fact that after controlling for average life and rating, ABS debt usually trades at a wider spread than comparable corporate debt. Given the wider-than-average spreads on ABS and the tighter-than-average spreads on corporate debt, there’s clear opportunity to rotate out of corporate debt and add spread and potentially pick up return from tightening in ABS. And since January saw 48 deals and more than $35 billion come to market, the largest January and the fourth largest issuance month ever, there are a lot of choices.

Investors currently can choose from an unusually broad set of ‘AAA’ ABS that trade at wider spreads than the limited number of ‘AAA’ corporate issuers. On January 23 and 24 this year, for instance, issuers brought ‘AAA’ debt to market backed by prime auto loans, prime auto fleet leases, subprime auto loans, credit cards, unsecured consumer loans and non-QM mortgages (Exhibit 3A). The debt spreads reflected a wide range of factors including issuer, liquidity, convexity and other risks. But the average ABS spread to the benchmark pricing curve—usually the Treasury curve—was much wider than the average corporate ‘AAA’ spread on the same day (Exhibit 3B). ‘AAA’ ABS debt with a 2-year weighted average life, for example, came to market at an average spread of 83 bp while 2-year ‘AAA’ corporate debt traded at a spread of 18 bp. ‘AAA’ ABS at every weighted average life traded wide to the ‘AAA’ corporate curve.

Exhibit 3A: Late January saw a wide range of ‘AAA’ ABS debt come to market

Note: Au Ln = Auto Loans Prime, Au Ls = Auto Lease, Au Su = Auto Loans Subprime, Au Fl = Auto Fleet Loans, Card = Credit Card, Cons = Unsecured Consumer, NonQ = Non-QM Mortgage Loans. New issue market spreads for 1/23/24 and 1/24/24.
Source: Asset-Backed Alert, Santander US Capital Markets

Exhibit 3B: The ‘AAA’ ABS debt cleared wide to the average ‘AAA’ corporate

Note: ABS reflects a fitted average of new issue market spreads for 1/23/24 and 1/24/24. Corporate spreads reflect the Bloomberg fair value curve for US ‘AAA’ corporate debt on 1/23/24.
Source: Asset-Backed Alert, Santander US Capital Markets

Investors could choose from a more limited set of ‘AA’ ABS, but the average still trades wide to the average corporate ‘AA’. ‘AA’ ABS debt on January 23 and 24 came to market off prime and subprime auto loans, unsecured consumer loans and non-QM mortgages (Exhibit 4A). The average ‘AA’ ABS traded wide to the ‘AA’ corporate curve. ‘AA’ ABS debt with a 2-year weighted average life came to market at an average spread of 146 bp while 2-year ‘AA’ corporate debt traded at a spread of 28 bp (Exhibit 4B). Again, ‘AA’ ABS traded wide to the comparable corporate across the curve.

Exhibit 4A: Late January saw a smaller mix of ‘AA’ ABS debt come to market

Note: Au Ln = Auto Loans Prime, Au Ls = Auto Lease, Au Su = Auto Loans Subprime, Au Fl = Auto Fleet Loans, Card = Credit Card, Cons = Unsecured Consumer, NonQ = Non-QM Mortgage Loans. New issue market spreads for 1/23/24 and 1/24/24.
Source: Asset-Backed Alert, Santander US Capital Markets

Exhibit 4B: The ‘AA’ ABS debt cleared wide to the average ‘AA’ corporate

Note: ABS reflects a fitted average of new issue market spreads for 1/23/24 and 1/24/24. Corporate spreads reflect the Bloomberg fair value curve for US ‘AA’ corporate debt on 1/23/24.
Source: Asset-Backed Alert, Santander US Capital Markets

A mix of ‘A’ ABS also came to market in late January and came also wide to the ‘A’ corporate curve. The ‘A’ ABS debt came from subprime auto loans, credit cards, a Fannie Mae credit risk transfer, non-QM mortgages and unsecured consumer loans (Exhibit 5A). The average ABS traded wide to the average corporate across the curve. ‘A’ ABS debt with a 2-year weighted average life came to market at an average spread of 172 bp while 2-year ‘A’ corporate debt traded at a spread of 43 bp (Exhibit 4B). The ABS curve again traded wide to the corporate curve across maturities.

Exhibit 5A: Late January saw a small mix of ‘A’ ABS debt come to market

Note: Au Ln = Auto Loans Prime, Au Ls = Auto Lease, Au Su = Auto Loans Subprime, Au Fl = Auto Fleet Loans, Card = Credit Card, Cons = Unsecured Consumer, NonQ = Non-QM Mortgage Loans. New issue market spreads for 1/23/24 and 1/24/24.
Source: Asset-Backed Alert, Santander US Capital Markets

Exhibit 5B: The ‘A’ ABS debt cleared wide to the average ‘A’ corporate

Note: ABS reflects a fitted average of new issue market spreads for 1/23/24 and 1/24/24. Corporate spreads reflect the Bloomberg fair value curve for US ‘A’ corporate debt on 1/23/24.
Source: Asset-Backed Alert, Santander US Capital Markets

Finally, a mix of ‘BBB’ ABS came to market in late January backed by subprime auto, credit cards, unsecured consumer loans, non-QM mortgages and Fannie Mae credit risk transfer (Exhibit 6A). The average ‘BBB’ ABS cleared much wider than the average ‘BBB’ corporate. ‘BBB’ ABS debt with a 2-year weight average life came to market at an average spread of 211 bp while 2-year ‘BBB’ corporate debt traded at an average spread of 86 bp (Exhibit 6B). The ABS curve traded wide to the corporate.

Exhibit 6A: Late January also saw ‘BBB’ ABS debt come to market

Note: Au Ln = Auto Loans Prime, Au Ls = Auto Lease, Au Su = Auto Loans Subprime, Au Fl = Auto Fleet Loans, Card = Credit Card, Cons = Unsecured Consumer, NonQ = Non-QM Mortgage Loans. New issue market spreads for 1/23/24 and 1/24/24.
Source: Asset-Backed Alert, Santander US Capital Markets

Exhibit 6B: The ‘BBB’ ABS debt also cleared wide to the average ‘BBB’ corporate

Note: ABS reflects a fitted average of new issue market spreads for 1/23/24 and 1/24/24. Corporate spreads reflect the Bloomberg fair value curve for US ‘BBB’ corporate debt on 1/23/24.
Source: Asset-Backed Alert, Santander US Capital Markets

Good fundamental value in household and consumer exposures

One legacy of post-GFC consumer debt reform and vigorous federal and state fiscal response to pandemic arguably is a consumer balance sheet that is significantly stronger. That may be a policy challenge for a Fed trying to cool the economy, but at current spreads it looks like good relative value for investors.

Most credit exposures—corporate or structured—should continue doing well as long as the market anticipates looser Fed policy in coming months and years. Credit has put up good returns, good demand for credit should continue and investors should let their winners run. But the US consumer also looks stronger than average while spreads in consumer exposures look wider than average. Portfolios holding comparable corporate debt at most rating levels can pick up substantial spread in ABS and, at least against a corporate or broader aggregate performance benchmark, add excess return.

* * *

The view in rates

The January FOMC persuaded the market that the Fed might not ease as much as thought, but only a little. The market priced for 125 bp of cuts before the meeting and closed Friday at 114 bp. The market-implied chance of a cut in March stood just below 50% before the meeting and closed Friday at 22%. The FOMC jawboning worked to rationalize the market a bit, with the curve flattening and risk spreads widening. Implied rate volatility dropped a bit after the meeting, but news of bank commercial real estate troubles has pushed it back up. Treasury liquidity remains relatively poor.

Other key market levels:

  • Fed RRP balances closed Friday at $513 billion, down $58 billion week-over-week and continuing a steady trend down since April. Treasury bills and Treasury and MBS repo all trade at yields above the RRP’s 5.30% rate. Money market funds continue to move cash out of the RRP and into these higher-yielding alternatives.
  • Setting on 3-month term SOFR traded Friday at 529 bp, down 3 bp week-over-week and broadly lower since September.
  • Further out the curve, the 2-year note closed Friday near 4.35%, 3 bp1lower on the week. The 10-year note closed at 4.13%, unchanged on the week.
  • The Treasury yield curve closed Friday afternoon with 2s10s at -35, flatter by 9 bp In the last week. The 5s30s closed Friday at 24 bp, also flatter by 9 bp over the same period.
  • Breakeven 10-year inflation traded Friday at 221 bp, lower by 8 bp over the last week. The 10-year real rate finished the week at 181 bp, down 4 bp in the last week.

The view in spreads

The January FOMC, reports of bank losses from commercial real estate and strong January payrolls have interrupted the regularly scheduled tightening of risk spreads. Liquidity is likely to trend lower through 2024 as QT and relatively high rates in the front end of the curve continue. Lower liquidity is likely to keep volatility elevated, keeping pressure on spreads, leaving them a tad wider than otherwise. Nevertheless, spreads should trade stable to tighter until at least March.

The Bloomberg US investment grade corporate bond index OAS closed lately at 96 bp, wider by 6 bp over the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 150 bp, wider by 8 bp in the last week. Par 30-year MBS TOAS closed Friday at 43 bp, roughly 2 bp wider over the last week. Both nominal and option-adjusted spreads on MBS look rich. Fair value in MBS is likely closer to 70 bp, so a widening toward 70 bp looks reasonable.

The view in credit

Most investment grade corporate and most consumer sheets look relatively well protected against higher interest rates, and eventual Fed easing should relieve pressure from interest rate expense and falling liquidity. Fixed-rate funding has large blunted 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. Consumer balance sheets also benefit from record levels of home equity and steady gains in real income. Consumer delinquencies show no clear signs of stress. 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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