KBRA Financial Intelligence

3 Things in Credit: Bank Risk, Corporate vs. ABS Spreads, and ECB’s Rate Cut

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Welcome, market participants, to another 3 Things in Credit. I’m Van Hesser, Chief Strategist at KBRA. Each week we bring you 3 Things impacting credit markets that we think you should know about.

So here we are, post-Memorial Day, so I have to ask, did you “sell in May and go away?” If not, beware. We’re wading into the period we’ve all been warned about—that leading up to the U.S. elections. Personally, I don’t think that’s going to mean all that much. Although we did get a chuckle coming across this bit from Bill Blain, who entertains us with his Morning Porridge newsletter (if you’re not familiar with it, do yourself a favor). Bill wonders what’s happened to us when the figures dominating the news and market flow are Nigel Farage, Donald Trump, and Roaring Kitty. To which we would ask, what does this say about the state of our evolution? Ponder that. In the meantime …

This week, our 3 Things are:

1. Banks. The FDIC is out with its quarterly assessment. Fresh data on all of those risks you’ve read about.

2. Corporate versus ABS spreads. There’s been a fairly dramatic move in the differential. We’ll explore.

3. ECB rate cut. It comes at a time when it forecasts higher inflation. Does that make sense?

Alright, let’s dig a bit deeper.

The state of the banks.

So, we got a good look at credit when the large banks reported Q1 earnings a couple of months ago. The most relevant development to us was the fact that the three of the four largest banks actually released loan loss reserves (that’s where new additions to reserves are less than actual loan losses). But we’re really interested in the other 4,564 banks—the ones with all of that risk we worried about in March of 2023.

Turns out, it’s not all that bad.

According to the FDIC, the banking industry continued to show resilience in the first quarter. That “r” word seems to be the official agreed upon descriptor used by regulators, and that’s OK with us. It beats many alternatives.

Overall profitability was plenty healthy, with return on assets coming in at 108 bps, well above the long-term industry average of 88 bps. Adjusted net income in the quarter was up 14.3% year-over-year on revenue gains of 3%. That all sounds consistent with an operating environment that features above-potential economic growth and structurally low levels of unemployment.

So, what’s happened to all of that fuss we lived through in the wake of Silicon Valley Bank a year ago? What about the rate rise that was threatening margins, the secular (and cyclical) shock undermining commercial real estate values, and the underwater bond portfolios?

Well, it turns out, it has all proven to be … manageable.

Sure, banks have had to pay more for deposits. But we know the deposit book doesn’t reprice to market levels in one fell swoop and loans do reprice faster than deposits. So, yes, in Q1 the cost of funding earning assets did jump to 2.59% from 1.61% a year ago. But the net interest margin fell by just 14 bps year-over-year to 3.17%, a level that is just 7 bps lower than pre-pandemic. It’s really not a big deal.

Delinquent commercial real estate loans did rise to its highest level since 2013, but 98.4% of CRE loans remain current. That figure, of course, is likely to continue to weaken as loss content in offices in particular grow as leases run off and refinancings happen. But those events happen over time, which will significantly reduce the shock effect as that first line of defense at banks—earnings—will also grow to absorb losses. We continue to see the CRE story as it impacts banks as a highly manageable one for the industry overall.

Unrealized losses in the bond portfolio remain large at $517 billion, that’s equal to 22% of the system’s equity capital. But remember, that depreciation does not have to be recognized, it simply represents a drag on earnings that will diminish in all probability over time. But for now, at this point in the cycle, the banks are plenty profitable to handle that drag and then some.

So, are we ready to sound the all clear? No, banks are cyclicals, and from a credit investor’s standpoint, it’s all about loan losses. And loan losses did jump 63% in Q1 versus a year ago. But this needs to be put into perspective. There is no question that banks “overearned” through the pandemic as stimulus in all of its forms held down loan losses. So, we should expect credit costs to normalize. We do take comfort that the loan loss provision in Q1 was only 2% above actual loan losses, so the industry is saying—at least thus far—that there has not been a significant revision of what future risk looks like. And that, quite frankly, is consistent with a soft landing. We continue to believe the banks are going to be just fine.

Alright, on to our second Thing—Secured versus unsecured spreads.

That soft-landing narrative has reshaped investor preferences across all asset classes; no great revelation there. But whenever you have a narrative shift it’s worth pulling back and testing whether or not the oftentimes inelegant repricing of assets makes sense.

Let’s look at the differential between corporate spreads and asset-backed spreads. Using the Bloomberg investment-grade Agg as our universe, the differential of corporate spreads less ABS spreads hit 100 bps at the height of the 2023 bank failure scare, above the 20-year average of 76 bps. That widening no doubt reflected the prominence of banks in the corporate Agg. Well, that differential has collapsed to 33 bps at the latest reading. In 20 years, we’ve only been this skinny at three other times, all during COVID. What does this tell us?

It tells us that investors have gotten comfortable with the bank story over the past year. It also tells us that the secular stories in ABS (CMBS, RMBS, and CLOs) are still correcting. Corporate spreads are 1.1x recent tights, while ABS spreads are 1.9x. Issuance has been heavy in both sectors, so let’s call that technical a wash. Investors continue to warm to ABS going by our most recent European Securitisation Survey (May 30), where sentiment was the most positive on the sector registered since our first survey done in June 2022. In the most tally, very few respondents feel that the market will widen at all. You can find all the details of our survey on our webpage.

In any event, safe to say that spreads across unsecured and secured are compressing, and whatever fat tail risks are out there, demand for high-quality paper yielding 5%+ figures to remain strong.

Alright, on to our third Thing—ECB rate cut.

Ordinarily, a 25-bp rate cut is not all that interesting or meaningful to broader credit markets, but there are some interesting perspectives on the ECB’s action Thursday. One, it is starting to ease despite increasing its forecast of inflation. Huh? You heard that right, it cut while increasing its forecast for core inflation in 2024 by 0.2% and in 2025 by 0.1% over what they forecast back in March. Unusual to say the least. So, what’s going on?

We believe the ECB is trying, at considerable risk to its credibility, to get this right. To recalibrate rates that are clearly restrictive, while preserving as much of growth as possible while acknowledging that inflation is still above target. Doesn’t sound all that revolutionary. Except when you take into account central bank motivations and history. Their modus operandi is to avoid becoming Paul Volcker or Jean-Claude Trichet, both of which had to reverse monetary course quickly during their respective reigns to address unforeseen (or miscalculated) circumstances. That means central bankers are incentivized to slay excess inflation beyond a shadow of a doubt, which means in almost every case they push economies into recession.

So, it’s no small feat that the ECB is trying to thread the needle of keeping growth positive while bringing inflation down to its 2% target. Part of its thinking is that it expects growth to accelerate, albeit modestly, which will contribute to the higher inflation it is forecasting. Still, rates need to come down for all of that to happen. It’s an interesting calculation.

We also like the ECB’s rather linear thought process guiding its actions. Madam Lagarde broke down the past into three phases: (i) hiking (aggressively) when inflation hit 10.6% in 2022; (ii) pausing, when inflation was cut in half in 2023 to 5.2%; and (iii) cutting, when inflation was halved again to today’s 2.6%. Importantly, and elegantly, she noted that the Bank has no intention to wait until inflation halved again (to 1.3%) because that would be below target. We are wary of linear thinkers—the world is far too messy to be that elegant or mechanical—but I must admit that framework makes a lot of sense.

By acknowledging that inflation remains an issue (and quite possibly could be a bit above target through 2025), we believe there are some structural drivers of higher-than-desired inflation confronting the world, namely, higher costs related to security of everything (food, energy, pharma, cyber, defense) and the energy transition. All the more reason to not be so dogmatic about the 2% target. The ECB seems to have struck a pragmatic tone today. Let’s hope the Fed follows suit.

So, there you have it, 3 Things in Credit:

1. Banks. The sector is proving to be resilient.

2. Corporate versus ABS spreads. A tight differential signals investor comfort with valuations.

3. ECB rate cut. A bold move to do the right thing.

As always, thanks for joining. Make sure you pick up recaps of the Global ABS conference in Barcelona. Insightful color on asset classes that are on the move.

We’ll see you next week.