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Post: : Credit carnage spurs bargains on bonds tied to $16 trillion pile of U.S. household debt

Big bargains have made a roaring comeback on bonds tied to the $16.2 trillion pile of U.S. consumer debt.

Higher borrowing costs, tighter credit conditions and sharp losses have been defining forces on Wall Street this year as the Federal Reserve has increased interest rates quickly to fight inflation stuck near 8%.

But the tumult also has investors in bonds tied to U.S. consumer and mortgage debt scouring for opportunities, as yields climb to crisis-era levels, even while the American labor market has remained strong at a 3.7% unemployment rate in October.

“I don’t think there’s an appreciation for just how cheap a lot of the bonds are out there,” said John Kerschner, head of U.S. securitized products at Janus Henderson Investors, which oversees roughly $15 billion of mortgage, auto and related assets out of about $80 billion in fixed-income globally.

Carnage in numbers

When consumers take out a car loan, tap their credit card or receive a home loan, pricing often hinges on conditions in the securitization market, where Wall Street for decades has been packaging up household and corporate debt to sell as bond deals.

In the wake of the 2007-’08 global financial crisis, financing for everything from subprime mortgages to credit-cards froze up, until the Fed slashed rates and took other measures to restart credit markets.

Credit has yet to dry up in this cycle, but rising interest rates since the Fed started raising interest rates have led the sector’s investment-grade bonds, debt rated AAA to BBB, to fetch high, single-digit yields, Kerschner said. For riskier bonds, with BB and lower ratings, yields have been closer to 13%.

DoubleLine CEO Jeffrey Gundlach touted similar yields in asset-backed securities and other parts of credit markets hit hard this year, despite rising recession risks, in a CNBC interview.

See: Now’s the time to buy ‘bombed-out credit markets,’ says DoubleLine’s Jeffrey Gundlach

Specifically, three-year BBB rated auto bonds, the lowest investment-grade bracket, were pegged at a spread of 410 basis points above the risk-free benchmark in October (see chart), up from a one-year low of 96 basis points, according to Deutsche Bank research.

Investors are being paid a lot more spread on consumer, mortgage debt

Deutsche Bank

Adding a spread of 400 basis points to the more than 4% benchmark 10-year Treasury yield

roughly equates to an 8% bond yield.

On riskier mortgage bonds called “Non-QM” by Wall Street that lack government guarantees, spreads hit a high of about 625 basis points in October from a 12-month low of 205.

Spreads still risk heading wider, according to BofA Global research, given “persistently high inflation, a hawkish Fed and a weaker economic outlook.”

Although, some parts of credit markets appear to be reflecting a degree of recession-level prices, with speculative-grade subprime auto bonds with BB credit ratings pricing at 12% to 13% yields in October, up from 5% in January, according to bond issuance tracker Finsight.

Subprime auto has been long considered a harbinger for household debt, because it often reflects the immediate economic hardship felt by wage-earners and borrowers with lower credit score when prices and borrowing costs climb.

Read: Why the car market might be ‘the harbinger’ of when the Fed can pivot

But with the hot jobs market, Deutsche Bank pegged 60-plus day delinquencies on subprime loans in auto bond deals at 4.55% in October, higher from a year ago but closer to prepandemic levels.

See: The U.S. jobs market is too ‘strong,’ the Fed says. So expect rising unemployment.

The Fed has been tightening the screws on financial conditions in an effort to pull inflation down from a near 40-year high to its 2% target, with this week seeing another jumbo 75 basis point rate increase and central bankers signaling that rates could stay higher for longer than initially expected.

“Something is bound to break when you do that,” said David Petrosinelli, managing director, sales and trading at InspereX, a broker-dealer, while pointing to yields in parts of the securitization market at their highest in a decade or more.

“There’s something afoot, but I don’t know if it gets as ugly as 2008,” he said.

It already has been a year of historical losses in bonds and painful losses in equities, as Wall Street has been forced to reprice assets as the 10-year Treasury yield has climbed quickly above 4% mark, from a December low of 1.34%. The 10-year yield is used to price consumer and corporate debt.

The hope from investors has been that the 10-year yield might be near a peak, potentially helping both bonds and stocks find a footing. The S&P 500 index

was down roughly 22% on the year through Friday, according to FactSet. As a proxy for the broader bond market, the iShares Core U.S. Aggregate Bond ETF

exchange-traded fund was about 17% lower for the same stretch.

But with bond yields now higher, it also could mean better days ahead for investors, particularly if the Fed can achieve its goal of avoiding a long, harsh economic downturn and high unemployment.

“It probably sets investors up for a very good return for 2023, because 2022 has been beyond awful,” Kerschner at Janus said.

Read next: Household balance sheets ‘remained strong’ and debt vulnerabilities are moderate, Fed survey finds

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