The Big Idea

Field notes

Steven Abrahams | July 22, 2022

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.

Whether it is in New York, Chicago or under the Las Vegas sun, a handful of issues seem to come up for debt investors often enough to matter. Recession. Portfolio positioning. The spread inversion between public and private debt. The eventual impact of tighter financing on markets and the economy. In some areas, there is consensus. In others, some investors are well ahead of the pack.

It all ends with recession

Recession has become the base case for most investors. It may not be for all investors, but in at least 18 discussions with insurers, asset managers and hedge funds in July, all assumed Fed tightening would end with recession. That’s not a surprise, and market indicators already say as much: an inverted yield curve, wide credit spreads, falling business and consumer sentiment. The bank earnings season has started, and many are putting aside new reserves for expected credit losses. The debate has shifted from whether the US will go into recession to the timing of onset, depth of recession and length.

The arguably more interesting question, raised by one investor, is whether there are low-probability, high-impact events that could break this consensus. A couple of possibilities:

A sharp de-escalation or truce in the Russia-Ukraine war
A relaxation or end to China’s zero-Covid policy
An end to Covid through vaccination or mutation of the virus
More fiscal stimulus either in the US, Europe or China
A halt or reversal in monetary policy tightening

China has already lifted infrastructure spending this year by 20%, according to CreditSights, and has authorized heavy debt spending for the rest of the year. The probability of a fiscal lift out of China may not be so low. But that could add to global inflation and keep the Fed on an aggressive path.

But an orderly recession

This recession should look different from the messy recessions of 2007-2009 and 2020 where parts of the financial system failed or teetered on the brink. Investor conviction here comes from the general strength of most corporate and consumer balance sheets and the Fed’s ability to buffer the worse-case scenarios. No large sector of the market or economy shows up on investors’ radar as likely to fall apart this time around with forced asset sales and pressure on market pricing and liquidity. Corporations so far have strong earnings and good access to cash, and investment grade companies extended debt maturities at low rates in the first two years of pandemic. For consumers, unemployment is low, income high and savings plentiful. The most vulnerable corner of the economy is the one served by the $1.4 trillion leveraged loan market, which funds almost entirely with floating-rate debt and would be pinched by higher rates and declining revenues.

Bearish on credit, bullish on MBS

Insurers and money managers mention allocating away from credit with some covering underweight positions in agency MBS. This came up with mutual fund managers and a few insurers, although the insurers are less inclined toward MBS. The bearishness for investment grade credit is not fundamental but more the risk of spread volatility if earnings soften, leverage rises and rating actions pick up. Leveraged loans and CLOs, however, involve both fundamental and technical risk:

Fundamental risks. The average loan started the year with 3-month term SOFR at 9 bp and a margin of 392 bp for a total cost of funds of 401 bp. Based on implied forward rates, the average loan will end the year with 3-month term SOFR at nearly 350 bp and, assuming no change in margin, a total cost of funds of 742 bp. The implied 85% rise in funding cost should put pressure on the average funded company that started the year with roughly $4 of EBITDA for every $1 of interest expense. With no change in revenue, the average company would end the year with $2.16 for every $1 of interest expense.
Technical risk in leveraged loans. An estimated $40 billion or more of leveraged loans now sit in CLO warehouses, based on US Bank reports, with 37% of those warehouses now aged nine months or more. As those warehouses approach maturity, pressure should build for them to either issues CLOs, inject more equity or start to liquidate positions. All of those should put pressure on leveraged loan spreads.

Constructive views on public markets, cautious views on private.

Spreads on some public debt are wider than spreads on private equivalents. That holds anecdotally for middle market loans, single-family rental properties and transitional real estate, among other assets, where bank warehouse lines for some well-established issuers offer tighter spreads than current public market debt. For investors that allocate to both, it has become harder to argue for locking up capital in private debt unless the private debt involves better collateral, better terms or both. Debt capital should start to redirect more toward public than private debt, and that should correct the spread inversion over time. Based on some recent reports, private debt is already reducing its footprint.

Even with recession, it all ends well

A few more philosophic investors see the market coming out of recession stronger. At least, that is, for most balance sheets. One big private equity sponsor and one student of banks both argued that parts of the nonbank financial system should get washed out by a higher cost of debt and lower leverage. Plenty of nonbank mortgage originators already have started laying off staff and going into survival mode. PE profitability should drop. Profitability at nonbank consumer lenders funded by banks should also drop. Lending volume falls, but the market end up in a wide range of relatively strong hands. The Fed may not need to rise to the rescue this time, and that should be healthy in the long run.

* * *

The view in rates

The yield curve looks like it has plenty of inversion left. The 2-year rate should approach 3.5% assuming a Fed more concerned about inflation than recession. Fair value at 10-year and longer maturities still looks solidly in the neighborhood of 2.50%, but the possibility of a sustained fight with inflation may require compensation above fair value even in long maturities.

Fed RRP balances closed Friday at $2.23 trillion. Yields on Treasury bills out to early October trade below the 2.30% rate on RRP cash likely to prevail after the July FOMC lifts rates by 75 bp. Money market funds have little alternative but to put proceeds into RRP.

Settings on 3-month LIBOR have closed Friday at 278 bp. Setting on 3-month term SOFR closed Friday at 256 bp.

The 10-year note has finished the most recent session around 2.77%, down 14 bp on the week. Breakeven 10-year inflation finished the week at 234 bp, down only 3 bp from a week before. The 10-year real rate finished the week at 43 bp, down 12 bp on the week.

The Treasury yield curve has finished its most recent session with 2s10s at -21 bp, unchanged on the week. The 5s30s finished the most recent session at 12 bp, steeper by 8 bp on the week.

The view in spreads

Although persistent volatility should make it hard for risk spreads to tighten, MBS should outperform credit as the Fed tightens and growth slows. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields finished the most recent session at 136 bp, tighter by 4 bp on the week. At this point, those spreads reflect the Fed path, volatility, balance sheet normalization and the risk of MBS sales. MBS OAS, on the other hand, continues to slowly tighten, suggesting good net demand. Credit spreads seem insufficient to cover the spread volatility likely as growth slows and concern about recession grows. After nearly two years of better performance in credit, the tide should start to turn toward MBS.

The view in credit

Credit fundamentals should soften as the Fed dampens demand and growth begins to slow. In some quarters, the conversation has turned from whether recession will arrive to the shape of recession once it does. Corporations have strong earnings for now, good margins for now, low multiples of debt to gross profits, low debt service and good liquidity. It will be important to watch inflation and see if costs begin to catch up with revenues. A recent New York Fed study argues inflation generally helps companies lift gross margins. A higher real cost of funds would start to eat away at highly leveraged balance sheets with weak or volatile revenues. Consumer balance sheets look strong with rising income, substantial savings and big gains in real estate and investment portfolios. Homeowner equity jumped by $3.5 trillion in 2021, and mortgage delinquencies have dropped to a record low. But inflation and recession could take a toll and add credit risk to consumer balance sheets.

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

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