Credit's Overlooked Hedge Against Inflation Risk
The writer of this articles says investors should consider leveraged loans as a tool to manage rising inflation risks to their portfolios.
With all the talk and data about inflation risks, we continue to take wealth managers’ views about how to manage the situation. Here are the opinions of Pieter Staelens, managing director and portfolio manager of CVC Credit Partners European Opportunities Limited. The editors are pleased to share these views and invite readers to respond. The usual editorial disclaimers apply. To contact the editorial team, email firstname.lastname@example.org and email@example.com.
While many column inches have been dedicated to the risk of inflation, its long-term impact is difficult to predict at this point in the economic cycle. There are obviously some transitory factors affecting the current high inflation numbers as the economic impact of COVID-19 continues, such as supply chain disruption, labour shortages and product shortages. This has been exacerbated by one-off events such as the Suez Canal blockage.
However, there may be some more permanent elements to inflation given the large amounts of money central banks have printed over the past decade and savings that have been built up since the start of the pandemic.
Faced with this uncertainty, how should investors think about their credit allocations and positioning their portfolios?
Base interest rates have remained at or near record lows in continental Europe for nearly a decade, meaning that a lot of investors have become used to ignoring interest rate risk in their portfolios. That is quickly changing, however, with the growing expectation that central banks will increase base rates to combat rising inflation.
Most recently, it was the Bank of England’s turn to come under pressure to hike rates after the Office for National Statistics reported an increase in UK inflation to 2.5 per cent while inflation pressure is on the up in the eurozone and the US too. The US Federal Reserve has also already hinted at potential rate increases in 2023, but many investors are speculating that a rate hike could come earlier than that to prevent the US economy from overheating.
Much of the noise to date has focused on the risk of holding bonds in an environment where base interest rates are increased by central banks to combat a rise in inflation. Bonds typically have a fixed interest rate - it remains unchanged for the duration of the bond’s term - meaning that its value moves in the opposite direction to interest rates.
However, for investors who still want to generate a secure, reliable income from their credit allocations, leveraged loans provide an often-overlooked alternative. Leveraged loans are mainly used by companies and private equity funds to finance M&A transactions. The asset class is less known in Europe as it is more difficult to access than the high yield bond market but is nonetheless significant at around €350 billion ($413 billion), having doubled in size over the past five years, and it is still growing.
Unlike most bonds, loans have a coupon or interest rate that is floating in nature - it gets re-set every three months and is linked to Libor or an alternative benchmark. This means that the loan’s value is protected from any increase in central bank interest rate hikes as its coupon will rise in step with them.