Will rising interest rates increase the attractiveness of private credit?
2022 seems, at least at first glance, to shake off some of the cobwebs of Covid and one important change expected is that rates will be increase – potentially several times. Something that has been a rare occurrence over the past decade.
Admittedly, the Bank of England’s last hike dates back to December 2021, which took the rate to 0.25% from 0.1%, where it had been squatting since the start of the pandemic. But the base rate hasn’t been in single digits since February 2009.
In this article, we look specifically at whether private credit markets will continue to thrive given the post-Covid macroeconomic backdrop and monetary policy outlook from here.
Floating rate nature of the asset class
Adam Wheeler, co-head of private finance at Barings is, unsurprisingly, broadly positive. “The outlook for private credit remains strong, particularly with investors and allocators looking positively at the asset class now that it has passed its first real test after the global financial crisis.
“In fact, the Covid-19 pandemic has confirmed the resilience of the asset class, demonstrating its ability to perform in downturns with limited volatility for investors.”
He concedes that there are, of course, outliers; and managers with a less defensive, lower quality portfolio with performance issues are likely to face challenges in the future.
“A key question for investors given the current macroeconomic outlook and monetary policy environment concerns the ability of private credit to perform in a rising rate environment.
“The floating rate nature of the asset class provides natural hedging, and managers with high quality portfolios geared towards borrowers with inelastic demand for their products or services, an ability to withstand wage inflation and cost pressures should be well positioned.”
Jo Waldron, director of private credit at M&G, takes a similar line. “We believe that short-term private and illiquid credit remains well positioned in all market environments, offering potentially higher risk-adjusted returns with lower asset value volatility than public equivalents for credit risk. equivalent.”
She adds: “In higher inflationary environments, the floating rate structure of the loans and instruments that make up much of the investable universe limits the effect of inflation and rising rates. Floating rate debt investors would benefit from a rising rate trend.
David Bizer, managing director of GWC Partners, can understand why investors have lately increased their interest in private credit over more traditional income-generating options.
He points out that macro conditions dominated bond performance in 2021. Investment-grade bonds, as measured by the Bloomberg Barclays US Aggregate Bond Index, recorded their seventh negative month of the year, down 0, 3% in December.
For calendar year 2021, bonds fell 1.5%, marking only the fourth year of negative performance since the index was created in 1976.
“Bond performance in 2022 will depend on the ability of major economies to recover from pandemic-related constraints and the success of central banks in convincing markets that inflationary pressures will be contained.”
M&G echoes the fact that in the current low yield environment, investors have found it more difficult to generate income from traditional fixed income assets. For some, this prompted them to look further down the credit spectrum for yield, knowing that assets bearing fixed rate coupons could see their value erode in a rising rate environment – especially those with lower spread profiles.
Waldron says it’s perhaps unsurprising that broader inflationary concerns have supported private and illiquid short-term credit. Essentially, loans linked to a short-term benchmark rate, often with clearly defined cash flow profiles and built-in investor protections such as financial covenants.
Recovery of the private market
Private market activity had come to a halt with the emergence of Covid-19, but has since strengthened.
After a buoyant year, demand for private credit from borrowers remains high, Waldron insists, as evidenced by the level of activity seen in several market sectors.
On the private enterprise lending side, Waldron sees several opportunities presenting themselves, potentially boding well for additional levels of capital deployment in the coming months.
She adds that mid-market companies recognize this by leveraging specific assets; such as property, inventory, receivables, machinery or equipment, they can obtain asset-based secured financing at a more attractive rate. “For private lenders, these investments can also offer a good level of return for the level of risk, being fully backed by collateral in various forms.”
However, investors have good reason to be cautious. Waldron believes some sectors have become increasingly expensive as excess liquidity drives yield lower into the credit spectrum, while others offer attractive relative value, compared to public market equivalents. .