Financial basis

Credit carnage spurs bond talks tied to $16 trillion pile of US household debt

Bargains made a strong comeback on bonds tied to the $16.2 trillion pile of US consumer debt.

Higher borrowing costs, tighter credit conditions and deep losses have been the driving forces on Wall Street this year, as the Federal Reserve has rapidly raised interest rates to combat inflation stuck at nearly 8%.

But the tumult also has investors in U.S. consumer-linked bonds and mortgage debt looking for opportunities, as yields climb to crisis-era levels, even as the U.S. labor market is remained solid with an unemployment rate of 3.7% in October.

“I don’t think people appreciate how cheap a lot of bonds are,” said John Kerschner, head of US securitized products at Janus Henderson Investors, which oversees about $15 billion in mortgage assets, automobiles and related. approximately $80 billion in fixed income securities worldwide.

Carnage in numbers

When consumers take out a car loan, use their credit card or receive a home loan, pricing often depends on conditions in the securitization market, where Wall Street for decades has packaged household and corporate debt to sell it. in the form of bond transactions.

In the wake of the 2007-2008 global financial crisis, funding for everything from subprime mortgages to credit cards froze, until the Fed cut rates and took other steps to revive credit markets.

Credit hasn’t dried up yet in this cycle, but rising interest rates since the Fed started raising interest rates have driven the sector’s investment-grade bonds, AAA to BBB-rated debt. , to achieve high single-digit returns, Kerschner said. For riskier bonds, with BB ratings and below, returns were closer to 13%.

DoubleLine CEO Jeffrey Gundlach touted similar returns in asset-backed securities and other parts of hard-hit credit markets this year, despite rising recession risks, in an interview with CNBC.

See: Now is the time to buy ‘bombed credit markets’, says DoubleLine’s Jeffrey Gundlach

Specifically, three-year automatic bonds rated BBB, the lowest tranche of investment grade, were pegged at a spread of 410 basis points above the risk-free benchmark in October (see chart) , down from a one-year low of 96 basis points. , according to Deutsche Bank research.

Investors are paid much more spread over consumption, mortgage debt

German Bank

Adding a 400 basis point spread to the benchmark 10-year Treasury yield of over 4% TMUBMUSD10Y,
4.163%
is roughly equivalent to a bond yield of 8%.

On riskier mortgage bonds called “Non-QM” by Wall Street that lack government guarantees, spreads hit a high of around 625 basis points in October from a 12-month low of 205.

Spreads are still likely to widen, according to BofA Global research, given “persistently high inflation, a hawkish Fed and a weaker economic outlook.”

Although parts of the credit markets appear to reflect a degree of recession-level pricing, speculative-grade subprime auto bonds with BB credit ratings ranging between 12% and 13% in October, down from 5% in January, according to bond issuance tracking tool Finsight.

Auto subprime mortgages have long been considered a harbinger of household debt because they often reflect the immediate economic hardship felt by earners and borrowers with lower credit ratings when prices and costs of borrowing increase.

Lily: Why the auto market could be “the harbinger” of when the Fed can pivot

But with the job market in turmoil, Deutsche Bank pegged 60-plus-day delinquencies on subprime loans in auto bond deals at 4.55% in October, higher than a year ago but more close to pre-pandemic levels.

See: The US job market is too “strong”, according to the Fed. So expect unemployment to rise.

The Fed has tightened the screw on financial conditions in a bid to bring inflation down from a nearly 40-year high to its 2% target, with this week seeing another 75 basis point rate hike and the central bankers signaling that rates could stay higher for longer than initially expected.

“Something is bound to snap when you do that,” said David Petrosinelli, managing director, sales and trading at brokerage InspereX, while pointing to yields in parts of the securitization market at their highest levels in a decade. decade or more.

“There’s something coming up, but I don’t know if it’s getting as ugly as it was in 2008,” he said.

It has already been a year of historic losses in bonds and painful losses in equities, as Wall Street was forced to revalue assets as the 10-year Treasury yield quickly rose above the 4% mark, to from a low of 1.34% in December. The 10-year yield is used to price consumer and corporate debt.

Investors’ hope was that the 10-year yield could be near a top, potentially helping bonds and stocks find some footing. The S&P 500 SPX index,
+1.36%
was down about 21% on the year through Friday, according to FactSet. As a proxy for the broader bond market, the iShares Core US Aggregate Bond ETF AGG,
-0.01%
exchange-traded funds was about 17% lower for the same stretch.

But with bond yields now higher, it could also mean better days for investors, especially if the Fed can achieve its goal of avoiding a long, hard economic downturn and high unemployment.

“That probably sets investors up for a really good return for 2023, because 2022 has been beyond awful,” Janus’ Kerschner said.

Read next: Household balance sheets ‘remain strong’ and debt vulnerabilities moderate, Fed survey finds