By Joy Wiltermuth
Big bargains have made a roaring comeback in bonds tied to the $16.2 trillion pile of US consumer debt.
Higher borrowing costs, tighter credit conditions and sharp losses have dominated Wall Street forces this year as the Federal Reserve has been quick to raise interest rates to combat inflation, which is stuck near 8%.
But the turmoil has also led investors in bonds linked to US consumer and mortgage debt to seek opportunities as yields rise to crisis-era levels despite the US job market posting an October unemployment rate of 3. 7% remained strong.
“I don’t think there’s an appreciation for how cheap a lot of the bonds out there are,” said John Kerschner, head of US securitization products at Janus Henderson Investors, which has about $15 billion in mortgage, auto and and related assets manages approximately $80 billion in global fixed income securities.
Carnage in numbers
When consumers take out a car loan, tap their credit card, or get a home loan, pricing often depends on conditions in the securitization market, where Wall Street has packaged household and corporate debt to sell as bond deals for decades.
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 action to get credit markets moving again.
Lending has not dried up this cycle, but rising interest rates since the Fed began raising rates has meant the sector’s investment-grade bonds, rated AAA to BBB, are posting high single-digit yields, Kerschner said. For riskier bonds rated BB and lower, yields were closer to 13%.
DoubleLine CEO Jeffrey Gundlach, in a CNBC interview, touted similar returns in asset-backed securities and other parts of the credit markets, which have been hit hard this year despite rising recession risks.
See: Now is the time to buy “bombed-out credit markets,” says DoubleLine’s Jeffrey Gundlach
Specifically, three-year BBB-rated auto bonds, the lowest investment-grade category, were priced at a spread of 410 basis points over the risk-free benchmark (see chart) in October, versus a one-year low of 96 basis points, according to research by Deutsche Bank.
Adding a spread of 400 basis points to the 10-year benchmark yield of more than 4% equates to roughly an 8% bond yield.
For riskier mortgage bonds, dubbed “non-QM” by Wall Street and lacking government guarantees, spreads peaked at around 625 basis points in October from a 12-month low of 205.
Spreads are still at risk of widening amid “persistently high inflation, a hawkish Fed and a weakening economic outlook,” according to BofA Global Research.
However, some parts of credit markets appear to be reflecting some level of recessionary pricing, with BB-rated speculative subprime auto bonds pricing in returns of 12% to 13% in October versus 5% in January, according to bond issuance tracker Finsight.
Subprime autos have long been seen as a harbinger of household debt because they often reflect the immediate economic hardship that wage earners and borrowers with poorer credit ratings feel as prices and borrowing costs rise.
Read: Why the auto market could be “the harbinger” of when the Fed can pivot
Amid a tight labor market, Deutsche Bank has fixed 60-day delinquencies on subprime loans in auto bond deals at 4.55% in October, higher than a year ago but closer to pre-pandemic levels.
See: US jobs market is too ‘strong’, says Fed. So expect unemployment to rise
The Fed has tightened financial conditions to bring inflation down from a near 40-year high to its target of 2%, with another jumbo rate hike of 75 basis points this week and central bankers signaling that rates are higher could stay longer than originally expected.
“There’s bound to be something broken,” said David Petrosinelli, managing director, sales and trading at InspereX, a broker-dealer, pointing to the highest returns in parts of the securitization market in at least a decade.
“There’s something going on, but I don’t know if it’s going to be as ugly as it was in 2008,” he said.
It’s already been a year of historic losses in bonds and painful losses in stocks as Wall Street has been forced to revalue assets as the 10-year Treasury yield has quickly surged above 4% from a December Low of 1.34%. The 10-year yield is used to rate consumer and corporate bonds.
Investors were hoping that the 10-year yield could be near its peak, which could potentially help both bonds and stocks gain traction. According to FactSet, the S&P 500 index is down about 21% for the year through Friday. Representing the broader bond market, exchange-traded fund iShares Core US Aggregate Bond ETF (AGG) was down about 17% for the same distance.
With bond yields higher now, it could also mean better days for investors, especially if the Fed can meet its goal of avoiding a long, hard economic downturn and high unemployment.
“It probably sets investors up for a very good return for 2023 because 2022 was beyond terrible,” said Kerschner of Janus.
Read further: Household balance sheets remained “strong” and debt vulnerability is moderate, according to Fed survey results
– Joy Wiltermuth
(ENDS) Dow Jones Newswires
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