KBRA Financial Intelligence

3 Things in Credit: Tight Spreads, Big Bank Credit Color, and Consumer Expectations

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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.

A quick programming post. This coming Tuesday, October 22, I will be sitting down to discuss credit markets with Scott Slayton, Chief Strategist of Capital Creek Partners, a multi-family office in Austin, Texas. Scott has a long, distinguished career as a portfolio manager and asset allocator, including Head of Asset Allocation at The University of Texas/Texas A&M Investment Management Company, more commonly known as UTIMCO, the largest public university endowment in the U.S. He also had stints at Morgan Stanley, Jamison Capital Partners, and Tudor Investments. [Listen in at] 10:00 am eastern, next Tuesday. Sign up on our website, KBRA.com, under the Events tab.

Alright then. Our word of the week is …. No, it’s not Donald Trump’s favorite word in the dictionary, “tariff” (!), which he revealed in a sit down at the Economic Club of Chicago. It’s “treacherous!” Jamie Dimon deployed that word in his bank’s earnings release this week that “recent geopolitical events show that conditions are treacherous and getting worse.” Not to be outdone, Vishal Khanduja of Morgan Stanley Investment Management said that fixed income markets are in a state of “treacherous Goldilocks,” with record fiscal deficits and an upcoming election that will probably make that worse. Something to look forward to.

This week, our 3 Things are:

1. Tight spreads. What to make of them?

2. Big bank credit color: Fresh earnings releases reveal how their credit exposure has performed, along with how they see it progressing.

3. Consumer expectations. We’ll dig into the New York Fed’s latest survey.

Alright, let’s dig a bit deeper.

Tight spreads.

I probably don’t have to remind you how tight credit spreads are. Both investment grade (IG) and high yield (HY) are at structural tights. And we’re compressed across the credit curve. IG to HY, BBBs to BBs, BBBs to single Bs—those differentials are all tight. Priced for perfection in a world that doesn’t strike us as, well, perfect. Few seem comfortable with this.

So, let’s delve into this a bit. Let’s start with investor motivations. The vast majority of bond buyers buy bonds for diversification and income. After the recent rate rise, yield buyers have returned in force, drawn in by the highest investment-grade yields in 15 years and less spectacular, but still appealing yields, in high yield some two points above where they were pre-pandemic. It’s a paradigm shift, and it’s likely here to stay as no central bankers, blessedly, are talking about a return to zero interest rate policy.

Now let’s view spreads in the context of competing asset classes. Starting with stocks, where the positive correlation between the VIX and spreads has broken down. And with the S&P trading at 22x forward earnings—a level hit just twice in the past 20 years, and where total return of the S&P 500 is up a whopping 36% over the past year—you can quite convincingly argue that upside in stocks over the near term is limited. As an alternative, many investors like the risk/reward of a 6% IG yield or 7.5% HY against that competition. Or at least as a complement to that competition. And that 6% IG yield compares favorably to the 4.5% (and likely headed lower) money market yield. Now, factor in the direction of rates. If you believe rates are coming down, you could see a path to price appreciation in bonds in addition to your coupon clip.

Let’s talk about sensitivity to market dynamics. Credit, especially BBs and higher, is built to easily withstand the typical economic and geopolitical news flow in this part of the cycle, namely, at or around trend growth. Larger companies—investment-grade companies—by definition have favorable market positioning and pricing power and superior financial flexibility. And in this cycle, firms across the credit spectrum have typically improved their balance sheets, having been able to refinance much of their debt stack at unusually low interest rates made possible by the Fed’s monetary accommodation during the pandemic. Now throw into the mix much better than expected economic growth and you have the kind of value proposition that garners durable investor interest.

One last thing worth mentioning. This spread environment has persisted through a heavy new issue calendar—one more thing that speaks to the appeal of the asset class at this point in time. So where does that leave us? Rangebound, at tight levels. Fundamentals are strong and technicals are strong. You might not like valuations but be careful fighting the tape on this one.

Alright, on to our second Thing—Big Bank credit.

Hopefully, it comes as no surprise that banks are lenders. So what better place to find out how consumers and businesses are faring than to take stock of how borrowers are doing, based on the quality of who the banks have lent to, and how those banks view the future opportunity. Q3 earnings releases out this week, give us an up-to-date perspective.

Let’s start with risk trends in loan portfolios overall. In a nutshell, they’re really good. Now, bear in mind that the largest banks overwhelmingly serve the advantaged part of our Two Economies we often refer to, namely, wealthier households and larger businesses. And in that sphere, results are extraordinary.

Overall, loan loss rates improved sequentially across the board. Loan loss reserve builds ranged from a modest release at Wells Fargo to a modest (4%) build at J.P. Morgan Chase, the latter due primarily to rising credit card loan volumes rather than loan deterioration.

The loan loss provision (reserves established for future loan risk) as a percentage of total revenue is trending lower across the board at relatively low, single-digit levels. The best comment I heard this past week was when BofA got to its credit quality slide, CFO Alistair Borthwick said, “There’s nothing really noteworthy to highlight on this page.” Au contraire, Mr. Borthwick. Nothing noteworthy is among the most important things you could say.

On the commercial lending side, nonperforming loans are all less than 1% of total loans, and none of the Big 4 showed an unsettling increase. And let’s not forget that in that nonperforming number is a pile of office loan exposure. That clearly remains a workout in progress, but that will happen over time, and those exposures at this stage are well reserved.

On the consumer side, any sign of delinquencies and losses rising above expectations—something we saw a year ago—has been addressed, meaning, credit boxes have been tightened on the margin. Now, we are seeing bad debt trends—those losses and delinquencies—continue to flatten out in the latest set of results. J.P. [Morgan] did affirm its credit card loss rate expectation for full-year 2024 at a quite reasonable 3.4%. Citi is guiding to 3.5% to 4% for its branded cards.

It is worth mentioning that in Citi’s private label card business, with a lower quality borrower skew than its branded cards, the company is guiding to the higher end of its 5.75% to 6.25% range. This gives us a window into the disadvantaged side of our Two Economies. The good news here is that delinquencies in that portfolio are stabilizing. And it’s worth mentioning that the current credit cost levels in both branded cards and private label are easily accommodated within the high yields these assets throw off.

To sum all of this up, the much better than expected economic activity in the U.S. coupled with management conservatism that 18 months ago prepared for something very different has resulted in really strong bank loan quality performance. And that reflects the strength of consumer and commercial borrowers in the aggregate, something that is clearly cushioning the economic landing we expect into 2025.

Alright, on to our third Thing—Consumer expectations.

So, we’ve established that the U.S. consumer is, to use the most fashionable word, resilient. J.P. [Morgan] says the consumer is on solid footing. Wells [Fargo] says it continues to look for changes, but they haven’t found any, and the level of spend is healthy. Citi says the consumer is becoming more discerning, but it remains healthy and, yes, resilient. BofA says consumer spending is normalizing, but in good shape.

The New York Fed is out with [its] latest Survey of Consumer Expectations and the findings are consistent with what the large banks are seeing. The press harped on the datapoint where 14% of those surveyed thought they might miss a minimum debt payment over the next three months, the highest level since April 2020. Yes, the reading has moved up four consecutive months, but only back into a more normal range. It certainly bears watching, especially given that the most pronounced increase in that 14% comes from households with annual incomes above $100,000, and 25% of households surveyed expect to be worse off financially one year from now.

Still, using Charlie Munger’s favored trick of flipping the data, that means that 75% of respondents believe their financial lot in life will be the same or better a year from now, and that points to the consumer being able to pilot this economy into a soft landing. But don’t lose sight of the not insignificant 25%, however. That is showing up in the University of Michigan’s Consumer Sentiment Index, which remains well below its long-term average (with data going back to 1952).

Treacherous Goldilocks, indeed.

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

1. Tight spreads. Don’t fight the tape.

2. Big Bank credit color. Loan quality among wealthier households and larger businesses is in excellent shape.

3. Consumer expectations. Cracks are forming in this “resilient” driver of the economy.

As always, thanks for joining. And sign up on our website for my conversation with Scott Slayton of Capital Creek Partners on October 22. We’ll see you next week.