Consumer demand has held up better than many expected in the face of stubborn inflation, a cooling labor market, ongoing tariff uncertainty and war in the Middle East. While the high-level data still support the case for a healthy consumer environment, a closer look suggests an increasingly bifurcated economy. As shown below, the top-earning 30% of households account for over 50% of total consumer spending while the bottom 50% account for less than 30% of spending. In other words, many consumers are far more financially constrained than the headline numbers imply.¹

Bond investors can gain exposure to the strongest consumers through high-quality credit card issuers and prime loan structures, but these higher-quality areas often don’t offer much incremental compensation. More attractive yield can be found further down the credit spectrum into near-prime and subprime borrowers, but performance can deteriorate quickly if the economy weakens.

We believe the tradeoff between yield and stability is where strong, bottom-up credit analysis becomes crucial. Today, data indicate early signs of consumer stress, including a modest uptick in delinquencies even within prime cohorts.² While it’s too soon to know whether that’s simply noise or the beginning of a broader trend, caution seems warranted.

The current environment suggests to us that the potential for losses has increased, highlighting the importance of credit investments that can remain resilient if economic conditions deteriorate. This means higher-quality tranches within consumer credit, for example, and a higher bar for investing in subprime opportunities. Issuer selection also remains key. Strong, proven issuers—particularly those with durable funding structures—are more likely to operate without disruption in tighter markets and therefore are less likely to create servicing transfer risk in a downturn.

The surging wall of maturities for payment-in-kind (PIK) loans, as shown in the chart below, may signal turbulence ahead. While not always indicative of distress, loans with PIK terms—which allow borrowers to add accrued interest to a loan’s principal balance rather than paying it in cash—generally have higher default rates and carry higher risk compared to traditional cash-pay loans.¹

Although reflective of a borrower’s desire to conserve cash, not all PIK loans are created equal. When included as an option at the time of a loan’s origination, PIK provisions may provide an effective tool for sound businesses to reinvest cash back into operations. Anticipating the possibility of interest payment in kind rather than cash, lenders can price the loan for greater risk upfront.

When appended to original deal terms for a borrower struggling to meet cash obligations, however, PIK amendments often signal potential impairment on the horizon. Unpaid interest expands the debt load and thus the leverage for an already cash-strapped borrower, which can significantly increase the probability of default on the loan and ultimately loss to the lender.

While PIK can sometimes staunch defaults in the near term, it often proves ineffective over the long run. The default rate for loans with appended PIK provisions can be 10 times higher than for traditional cash-pay loans and recoveries tend to trail cash loans (by about 1,000 basis points over the last two years, for example).² Further, the non-cash income received by lenders can strain liquidity for investors. This liquidity strain may thwart exit opportunities—through refinancing or sale of the company—due to increased leverage and higher loan-to-value ratios.