KBRA Financial Intelligence

3 Things in Credit: Private Placements, Fallen Angels, and Housing

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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.

We’re just about at the end of Q1 earnings season, and the numbers in the aggregate are good. S&P 500 earnings were expected to grow 3.8%, and with 490 companies reporting we’re at 7.8%. But underneath? It’s becoming a story market. Starbucks underperforms the S&P on release day by 16%; Chipotle outperforms on its release day by 7%. Kohl’s underperforms by 22%; Walmart outperforms by 7%, Booking.com outperforms by 2%; Expedia underperforms by 16%. So much for the rising tide lifting all boats.

This week, our 3 Things are:

1. Private placements. The Chicago Fed has a surprising take.

2. Fallen angels. A soft landing should provide … well, you know.

3. Housing. What’s the latest?

Alright, let’s dig a bit deeper.

Private placements

This week, the Chicago Fed took stock of the private placement market in a two-part series, the first titled “A Primer” and the second, “Increasing Complexity.” The focus for both pieces is from the perspective of the life insurers that buy privates, but the papers really speak more broadly to the private market.

This comes at an interesting time, where you have certain insurance buyers leaning hard into the private market. The aggregate data shows that over the past 20 years, life insurers have shifted more of their bond investments to privates, from 13% in 2004 to more than 20% in 2022. Even so, privates as a percentage of general account assets have barely risen over that time frame, going from 10% to 11%. That doesn’t seem all that earth-shattering to us. But underneath the aggregate data, there is real movement.

Here’s a 2023 quote from Marc Rowan, CEO of Apollo, which owns insurer Athene: “Athene’s entire business is built on the notion of stepping back from public markets and earning 200 to 300 basis points over investment grade for taking less liquidity … not by taking incremental credit risk.”

Interestingly (and consistent with Mr. Rowan’s remarks), the Fed lists four benefits of privates over publics:

1. Privates’ longer-dated maturity composition better aligns with life insurers’ longer-dated liabilities.

2. Privates diversify and complement insurer holdings of publicly traded bonds by opening up a broader set of companies and assets, including infrastructure/utility-related debt and issues from small- to medium-sized companies.

3. Privates offer enhanced credit protections, including, typically, covenants, which investors can negotiate before issuance.

4. Privates tend to earn higher risk-adjusted returns due to complexity and illiquidity premiums.

The Fed adds that “the increase in private placement investments does not appear to have resulted in a deterioration of the credit quality of private placement investments.” Wow. From the regulator, that adds up to a full-throated endorsement of the private market.

Now, the Fed does point out in its second piece on the topic that “continued increases in private placement holdings, and especially more complex securities, raises concerns about life insurers’ liquidity position in times of stress.” That strikes us as overblown. Utilizing the Charlie Munger practice of inverting data, that means 80% of insurer bond holdings are not privates. And remember, life insurer investments are matched in duration to their liabilities. Unlike their property and casualty counterparts, life insurer cash needs are far more predictable.

Taking all of this into consideration, we agree with the Chicago Fed on the benefits of private credit. Don’t let the headlines distort reality.

Alright, on to our second Thing—BBB risk.

We admit to being a bit alarmed at a headline in the Financial Times this week: “More U.S. high-grade borrowers at risk of downgrade as economy slows.”

I guess conceptually that isn’t an alarming statement; that’s the way ratings work. But the tone implies something more ominous. Like the first line of the piece: “A rising share of the high-grade market is at risk of being slashed to junk … ”

The article is reporting on a piece by BofA Securities, which simply tracks low BBB credits on negative watch or negative outlook. That total is 5.7% of low BBBs, up from 2.9% at the beginning of the year. Let’s bring Charlie Munger’s inverting data back into this discussion. That means that more than 94% of low BBBs are just fine. BofA acknowledges as much, adding that investment-grade fundamentals are “generally strong.” It is worth pointing out that two large credits, Paramount and Boeing, have only recently been pushed to the proverbial ratings cliff. Boeing, for all of its issues, has more staying power than your average low BBB given its importance to U.S. national security.

We would add that BBB credits, by definition, have plenty of staying power, albeit with a few points of vulnerability. That means a business that typically makes sense and is competitive, coupled with a reasonably solid balance sheet and a degree of financial flexibility. Put another way, while BBBs, by definition, may be vulnerable to a recession, they typically have the ability to ride out economic slowdown, a soft landing.

And if you believe in the wisdom of crowds, the market seems none too worried. BBB credit spreads are at or near 20-year tights at 105 bps, versus the long-term average of 187 bps. So, clearly markets are not all that concerned that a wave of fallen angels is on the way. And with BBs also well bid, and, by definition, able to withstand the headwinds presented by a soft landing, we would expect any fallen angels to be well bid upon entry. We don’t think there is much of a story here.

Alright, on to our third Thing—Housing.

Every time we hear of a no-landing narrative or how monetary policy no longer transmits, we remind people of housing. It’s been in a world of hurt ever since the Fed decided it needed to hike. We’re speaking, of course, in terms of activity rather than homebuilder credits or mortgage credit quality.

So, from the start of the Fed’s tightening cycle, that would be March of 2022 until now, the impact on housing has been breathtaking. In fact, this is the fastest Fed-driven housing slowdown on record. By a lot. I guess that’s the point, from the Fed’s perspective.

At the risk of stating the obvious, the issue with housing this go-around is not home price depreciation. It’s the opposite. Diminished affordability has hit broadside a sector that contributed 18% to U.S. GDP in 2023. It is worth pointing out that the wealth effect related to soaring home values has been, and will continue to be, an important driver of consumer spend. So, it’s not all bad.

Notwithstanding that benefit, why we can’t seem to reverse the persistent shortage of homes, estimated to be 2.5 million by Realtor.com, remains a bit of a mystery. Sure, higher construction costs, limited labor, tight bank lending standards, and limited visibility have kept homebuilding below potential for some time now. And, from the consumer’s standpoint, the spike in rates means sticker shock remains high, credit remains tight, and inventory is low. Now you understand the “Let’s give up on the dream and go see Taylor Swift in Tokyo” refrain.

But maybe, just maybe, we’re seeing some green shoots. Household formation has picked up again. Low unemployment is a positive catalyst. There is a strong incentive to move from high-cost jurisdictions (California, New York, Illinois) to low-cost ones. Listings are on the rise, as is residential construction. While surveys tell us it’s a terrible time to buy a home, we are finally seeing those planning to move bouncing off of the bottom.

I’m sure the Fed is wondering why the economy broadly hasn’t slowed sufficiently at this point to reverse monetary course. But as we get closer to easing, even a little bit, and the shock of sticker shock diminishes, housing figures to get up off its back. And that’s good for credit.

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

1. Private placements. The Chicago Fed nicely lays out the positives.

2. Fallen angels. It’s much less of an issue in a soft landing.

3. Housing. It’s starting to come back.

As always, thanks for joining.

We’ll see you next week.