Many borrowers with subprime credit have been hit hard by the Federal Reserve's inflation fight, resulting in higher interest rates on new auto loans. According to Fitch Ratings, the average annual percentage rate (APR) for a loan in recent subprime auto bond deals has increased from around 14% last year to a range of 17% to 22% this year.
The consequences of higher borrowing costs are significant for lower-income households. With more of their income going towards monthly auto payments, the risks of late payments, defaults, and car repossessions become increasingly likely. However, despite these risks, investors continue to show confidence in the subprime auto sector.
So far this year, nearly $30 billion of new bond deals have been cleared in the subprime auto sector, slightly below previous years but still above historical levels since 2008. However, as Tracy Chen, a portfolio manager at Brandywine Global Asset Management's global fixed income team, warns, there may be a reckoning if rates remain elevated for an extended period.
Determining when this tumult might occur has proven to be a challenge. Despite the Fed raising its policy rate to 5.25% to 5.5%, the economy has displayed resilience. The central bank has signaled its intention to keep rates high to combat inflation. As a result, longer-duration bond yields have increased but still remain below 5%.
Inflation particularly affects lower-wage workers' paychecks, and the Fed aims to address this problem by maintaining elevated borrowing rates. Consumer prices remained steady at a yearly rate of 3.7% in September, exceeding the Fed's 2% target.
Tracy Chen believes that while a recession is likely to occur in the middle of 2024, significant damage could happen before then if rates continue to stay high. As the Federal Reserve prioritizes inflation control, subprime auto loans face an uncertain future.
Shift in Fed Policy
According to EY Chief Economist Gregory Daco, the focus of Fed policy makers is shifting from raising interest rates to maintaining them at restrictive levels. At the next meeting in November, it is widely expected that the Fed will hold rates steady.
Market Reaction
Following the release of the inflation report, stock prices were relatively stable, with the Dow Jones Industrial Average remaining largely unchanged and the S&P 500 index experiencing a modest increase of 0.2%.
Subprime Auto Bonds
Investors in subprime auto bonds have yet to demand significantly higher compensation to offset the possibility of higher defaults among borrowers. These bonds continue to be seen as a lucrative investment opportunity with relatively low delinquency rates.
Bond Pricing
A recent bond deal in the subprime auto sector showed an increase in spread compared to a similar bond issued earlier. The AAA rated 2-year slice of the bond deal priced at a spread of 115 basis points above the relevant risk-free rate, up from 90 basis points in the previous bond issued in August. When considering Treasury rates, the yield on these bonds reached approximately 6%. Despite these changes, investor confidence remains high.
Delinquency Rates
The rate of subprime auto loans that were at least 60 days past due in bond deals was around 5% in September, as reported by Intex. This is an increase from the historic lows of around 2.5% two years ago.
Conclusion
Despite concerns about subprime auto defaults potentially reaching levels seen during the 2008 financial crisis, investors in subprime auto bonds continue to express confidence. The combination of higher returns and relatively low delinquency rates appears to be contributing to this confidence.
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