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 tom.burroughes@wealthbriefing.com and jackie.bennion@clearviewpublishing.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.  

Smart institutional money is already making this move to position portfolios for rising inflation. In the first half of 2021, the Lipper Fund Flow Report recorded $20.3 billion of inflows into US loan funds and $15.7 billion outflows out of US High Yield Bond funds.

While the equivalent data for Europe is less readily available, the smartest investors will not only be reducing their high yield bond exposure to protect themselves from future interest rate hikes but also to gain access to the current performance of the loan asset class. At 30 June 2021, the yield - earnings generated and realised on an investment over a set period of time - of the Credit Suisse European Leveraged Loan Index was around 3.7 per cent, whereas it was 3.1 per cent for the High Yield Bond equivalent index.

The European loan market has benefitted enormously from the increase in M&A volumes and private equity-backed transitions in recent years. Its growth has benefitted managers like us by allowing us to diversify our portfolios even more by sector and geography. For example, in our portfolio we typically have around 100 positions, implying that the average position is 1 per cent of the total. This helps us protect ourselves against the risk of unforeseen disruption to a particular sector, geography or individual borrower that might impair their ability to continue re-paying the loan. As such, we can insulate our end investors from any volatility within the portfolio better when it comes to delivering returns. 

The main risk faced by loan investors is, of course, that one or more of the companies they lend to becomes unable to repay the loan and falls into default. There is then a risk that the lender is unable to recoup their original investment and a loss will be passed onto the end investor. However, default rates in the European leveraged loan market have remained low over the past five years, currently estimated by Credit Suisse at 0.5 per cent and only reaching 1.2 per cent in 2020 during the pandemic. To put that in perspective, following the Global Financial Crisis, European leveraged loan default rates peaked at around 10 per cent in 2009. 

Even in an environment where default rates are increasing, leveraged loans have the additional benefit of being senior to high yield bonds in the capital structure, meaning that they have security over a borrower’s assets. As such, in the event of a default, the actual incurred losses should be lower than for high yield bonds.

The debate over the best way for investors to protect themselves against inflation and subsequent interest rates hikes will undoubtedly continue to take up much of the attention of commentators. However, for investors seeking to generate a secure income while simultaneously hedging against inflation, they could do worse than consider leveraged loans and would do well to note that since the Credit Suisse Leveraged Loan Index began in 1998, it has only once had a down year.