KBRA Financial Intelligence

3 Things in Credit: Powell’s dilemma, FICO rolls over, and Direct lending update.

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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, coming into the week, the S&P 500 had positive gains in 16 of the previous 18 weeks for the first time since I was … well, for the first time since 1971! I don’t know if we’ll make 17 of 19, but if we did, that would be the first time since 1964. I hope you’re long stocks in the personal account. Or at least Bitcoin, Jamie Dimon’s favorite Pet Rock, which hit record levels this week. Do we care? Maybe. Lisa Shalett, Chief Investment Officer at Morgan Stanley Wealth Management, said Bitcoin is “the ultimate sentiment indicator.” Hmmm. It indicates something, I guess.

This week, our 3 Things are:

1. Powell’s dilemma. To cut or not to cut. It’s not just data dependent. We’ll explain.

2. FICO scores. They’ve hooked over for the first time in a decade. What does that mean?

3. Direct lending default and recovery rate surprises. Eric Rosenthal is along to bring you up to date.

Alright, let’s dig a bit deeper.

Powell’s dilemma.

We sat down with a couple of Financial Institutions bankers this past week (you know, bankers covering banks), and the discussion naturally turned toward the Fed—does anything else matter? We got to talking about the predicament Fed Chair Powell finds himself in. As a pragmatist (as opposed to a model-driven academic), the Fed Chair, from our perspective, has always been guided more by the growth side of his dual mandate: Keep the economy going. That will help him achieve what I think he thinks is his true mission—maximizing social welfare in America. Let the forces of deflation—automation, technology, and globalization—take care of price stability.

All of which brings us to an interesting crossroads if you’re Jay Powell. Should the Fed cut rates, it would ease the pain that higher rates—7% mortgages, 11% middle market loans, and 24% credit card loans—are having on middle- to lower-income folks as well as small to midsized businesses. Cut rates and it would lessen the threat that the commercial real estate correction poses to banks, the safety and soundness of which, it goes without saying, the central bank is responsible for. Pretty strong arguments in favor of cutting rates.

Yet, you’re looking at historically low unemployment, gains in real income, and highly accommodative financial conditions. Services inflation ex-shelter is going the wrong way. Grab that punch bowl!

Leave rates higher for longer, and you stand a better chance of taming inflation down to target—and enhancing what seemingly every central banker craves: credibility among your peers. You had the intestinal fortitude to stand in there against the vagaries of politicians and markets. But in doing so, you also increase the likelihood of hardening the economic landing.

Therein lies the predicament.

We have long said that the incentives for this Fed, as it was for just about every Fed before it, point to overshooting. Not only does that strengthen your credibility among your peers (check that box), but it also significantly reduces the prospect of having to raise rates again to finish the job. Somehow that scenario is deemed to be a failure—you didn’t do your job. It’s all or nothing.

So, all this tells us that in this cycle, following the lead of past cycles, Jay Powell knows what job one is: Get inflation down to target, sustainably. And that tells us that rates are likely to remain restrictive over the balance of the year. That’s less relief to borrowers, which means less relief to the banks and commercial real estate. We haven’t changed our view of three second-half cuts, but put that in perspective: 75 bps clawed back after 525 bps of hikes. In other words, back to normal.

Alright, on to our second Thing—FICO rolls over.

Fair Isaac Corp., that which tabulates the ubiquitous FICO consumer credit scores, reported that for the first time in a decade, the national average FICO score dipped. Management observed that the latest data suggests “the effects of high interest rates and persistent inflation may be starting to weigh on consumers.” In a world searching for—and where some are questioning the very existence of—the lagged effects of monetary policy, here seems to be some evidence. Management acknowledged that this “isn’t a blinking red light, but it certainly is a yellow light.”

Deterioration among consumer loans is not news. Our own KBRA Marketplace Consumer Loan ABS Indices have tracked and reported on trends in consumer loan categories over the course of the pandemic era, reflecting first on the benefits of stimulus to consumer borrowers, followed by the normalization of credit quality trends as those benefits wear off and as inflation takes its toll. The question for borrowers, lenders, and investors has been, what will this normalization look like?

So, we were a bit taken aback by Fair Isaac’s characterization of the latest result, which is as of October 2023. Yes, it did fall from the previous reading (July 2023), which was a record level of 718. The average, going back to October 2005, is 699. So, yes, it probably is noteworthy that directionally, it seems that the data has hooked over. But is it all that worrisome?

To that question, the company does provide some additional color. Consumer Missed Payments are up 4% from April 2023 levels. Missed Payments on auto loans and mortgages remain below pre-pandemic levels, while Missed Payments on credit cards now exceed pre-pandemic. Management believes that the more challenging economic environment is taking a greater toll on those that meet everyday expenses with credit cards.

Management went on to add: “Our latest credit score data provides evidence of persistent increases in default rates and re-leveraging of consumer debt. Whether this average score drop is an anomaly, or an early warning of an inflection point in consumer repayment behavior will depend on a few factors: will high inflation and elevated consumer prices continue to place financial stress on borrowers and lead to more missed payments and increased debt levels?” Relevant questions for sure.

We also know that credit scores like FICO were pushed higher during the pandemic as stimulus enabled many borrowers to not only pay back debt on time but also pay down debt. As those benefits wear off, scores should come down. So, back to our opening question. Is a one-point dip off of an unnaturally high number all that worrisome? The answer is no. Are we seeing worrisome trends in some lower-income, lower-quality borrower cohorts? Yes. But, in the aggregate, normalizing trends in consumer credit are well behaved at this point in the cycle.

Alright, on to our third Thing—Direct lending default and recovery rate update, courtesy of KBRA Analytics.

Joining me today is Eric Rosenthal, who generates our default forecast as part of his work with KBRA DLD, our direct lending news and analytical platform.

Van: Eric, welcome back to the podcast.

Eric: Thanks, Van, for having me back.

Van: So, Eric, the Federal Reserve recently released a report using KBRA DLD data showing direct lending recoveries below that of both syndicated loans and high-yield bonds. This struck many as a surprise. Talk about what you found.

Eric: For sure, as I've gotten several inquiries on this topic. Recovery rates (based upon fair value at time of default) for first-lien private loans have improved since the Fed showcased our October numbers. The trailing 12-month direct lending recovery rate stands at 54% by number and 62% by par amount.

This is essentially in line with syndicated loans at 57% and 55%, respectively, and also above high-yield figures. Now we caveated our monthly report, and weekly commentaries of the direct lending recovery sample are thin. There are just 14 first-lien observations compared to 73 for first-lien syndicated loans. Nevertheless, any notion that direct lending recoveries at the time of default are going to finish significantly higher in the near term (so, it doesn’t say, like, the 70%+ territory) would be as wishful as the Mets winning the World Series.

Van: Well, Eric, I guess hope does spring eternal. Anyway, what are you seeing that makes you believe recoveries will stay low?

Eric: Our default radar, Red List, which highlights the most worrisome credits, has an average fair value of just 60. While not all of the 96 Red List borrowers will default, for those that eventually will, they will likely face further fair value declines. I say this because the BDC fourth quarter marks for the Red List issuers have been painful, unlike the positive results for the overall market. In total, 69% of the Red List issuers have experienced fair value decreases versus the third quarter. In fact, 30% have been marked down by greater than 10 points. There are currently 29 issuers with fair values at 50 or below. And if and when they default, they will drag down the recovery average.

Van: So, any other important direct lending recovery takeaways?

Eric: The average three months prior to default values are significantly higher in direct lending than in either syndicated loans or high yields. Now, while the latter two markets experienced roughly a 7-point drop over this time frame, direct lending fell by 23 points. This steep decline is likely due to BDCs’ reluctance to mark weaker credits lower, rather than, say, company-specific issues that were occurring all of a sudden. With the broadly syndicated and high-yield markets, though, defaults are usually already priced more in advance. Therefore, the three-month change is often minor, as opposed to, say, direct lending.

Van: Alright, I think I've got it. So, recoveries look bleak, but are there any positives you're seeing out?

Eric: Definitely. So, the trailing 12-month loss-given default rate is staying at just 1.1%, and that's well below syndicated loans and high yields at 3% and 2.5%, respectively. The trailing 12-month direct lending issuer default rate is at 2.1%, and that's down from 2.3% at year-end 2023. There have been just two defaults so far this year.

Van: Well, that doesn't sound so bad, but how does this rate stack up to syndicated loans and high-yield bonds? Any changes to your 2024 forecasts?

Eric: Right, the trailing 12-month syndicated loan issuer default rate is much higher—we’re talking 6.5%—and there have been a whopping 83 defaults. On a par-weighted basis, the default rate stands at 4.3%. So, our 2024 forecast was 5.75% and 4%, respectively. And while the numbers are currently a shade above our projections, I'm still comfortable with our 2024 predictions. For high yield, we forecasted a 3.75% issuer and 3% par-weighted default rate. The trailing 12-month figures are also a smidge higher, at 4.1% and 3.4%, respectively.

Nevertheless, high-yield default activity year-to-date has been fairly muted, and our default radar Red List has only 19 names. So, thus far, the five year-to-date high-yield defaults tally $3.7 billion, and that's well below the 18 defaults for $17.7 billion for syndicated loans. And we mentioned on the podcast earlier this year that syndicated loan default volume is expected to exceed high yield by the largest margin ever. And, while early, that is how it's playing out.

So, similar to loans, I don’t anticipate any high yield forecast change. On the other hand, we could revise down our 2.75% direct lending forecast for 2024. Fourth quarter fair values across the KBRA DLD index show positive results thus far, with 39% improving versus 24% declining. These findings bode well for default rates, remaining benign in the near term, despite the 96 default Radar Red List issuers that I mentioned earlier.

Van: Well, I think all that squares up with this soft-landing narrative that is emerging here. So, remind us of the scope of what you're doing and where we can find more information.

Eric: Sure. We publish on a monthly basis both a direct lending and a liquid monthly default report. Plus, we have weekly default commentary on both markets, and you can find these on our website at dld.kbraanalytics.com.

Van: Terrific. Thanks for joining us today.

Eric: Thanks again for having me.

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

1. Powell’s dilemma. The incentives still point to overshooting.

2. FICO scores. They’ve hooked over for the first time in a decade. We’re not all that concerned.

3. Direct lending developments. They continue to be well behaved.

As always, thanks for joining. See you next week.