Analysing the impact of rising rates on private credit
In terms of the latter, The Federal Reserve (Fed) had not hiked rates since 2018, after it embarked upon tapering and hikes over a two-year period. As the Fed continues the path of rate hikes (currently up to 2.5% after two 75bps hikes over the summer 2022), inflationary pressures will be the main decision-driver for the Fed. As high inflation prints continue, the Fed has already eliminated transitory inflation from its vocabulary and more hikes are expected this year. In Europe, the hangover from the GFC is more profound given the Sovereign Debt Crisis in 2011, resulting in the European Central Bank (ECB) leaving rates at the zero bound when the Fed started its initial hike in 2016.
Investors are now weighing up their options in such an environment as they consider stable cashflows from coupons that offer some element of downside protection. This piece discusses the impact of rising rates on private credit. With Waystone’s experience and vast client base being predominately based in the mid-cap private credit space, the focus is on direct lending to mid-cap within Floating Rate Notes (FRNs).
Recent developments in monetary policy
Hikes in Europe were further stifled due to a fragmented response across the Continent due to Covid and the war in Ukraine. However, as supply-chain issues and inflated commodity prices jolted the ECB into action, they surprised markets in the summer with a 50bps increase – the first in 11 years. With the additional rate hike of 75bps in September, more hikes in Europe are expected. In both cases, the Fed and the ECB are hiking within low-growth (or negative) environments. For Europe, the war in Ukraine impacts a recessionary scenario for Europe given its dependence on Russian gas. Another point to consider in Europe is the already indebted Italian economy as it grapples with yet another political crisis with the resignation of Mario Draghi in the summer, along with a new Prime Minister potentially elected late September.
Senior secured FRN coupons
The loans in the mid-cap space are typically senior in the capital stack, secured by some of the collateral and with the benefit of strong financial-driven covenants to protect the investor. Another feature of private loans is the amortisation feature, where repayment schedules reduce the risk of the loan relative to longer-weighted average life positions such as High Yield Corporate Bonds with a one-off payment at maturity. The FRN format of the loan is set up in order that the reference rate (now SOFR rate) resets every quarter, with the margin fixed upon the inception of the deal. The reference rate moves in line with the interest rates set by the markets (typically 3-month SOFR rate or EURIBOR in Europe). Most of the loan documentation includes the presence of reference rate floors (LIBOR-floors) in the range of 50bps to 100bps to protect against rates hitting zero and no income earned when holding the loan. Within the higher rate environment, particularly in the US, FRN loans and bonds are generating considerably more income for fund investors – some of which is distributed with the rest recycled into new investments.
Impact on credit
Throughout the credit cycle, a number of factors evolve to influence the initial investment with a borrower; margin or coupon, documentation strength and presence of covenants. Typically, in a ‘Risk-on’ environment the lending process becomes more competitive as more investors are willing to put money to work and the bargaining power shifts to the borrower; coupons decline, documentation weakens, and the number of covenants reduce or disappear. Conversely, when we reach a ‘Risk-off’ market, the lender takes control and increases the coupon, strengthens the documentation, and incorporates more onerous covenants. As we have seen more recently, the more volatile market conditions should result in credit markets shifting to ‘Risk-off’, thereby increasing spreads and expected coupons.
Making the comparison between the HY bond market and the current environment (particularly in Europe) where rates are expected to increase, negatively impacts fixed coupon positions to a greater extent relative to the FRN. As inflation increases, investors should be rewarded as their purchasing power has been eroded. However, in FRN format, the reference rate accounts for the increasing rate environment. For example, using the S&P LCD Index as a proxy for mid-cap loans and the BoA HY Index (taken from Bloomberg), the cash price moves for mid-cap loans ranged from 99% to 96%, whereas the HY bond moved from par to 85%. As such, the HY bond market will be impacted by large moves in the case price purely based on rates, not on credit, and will display huge variations in interest rate sensitivity relative to loans in FRN format. In addition, the default rate in mid-cap loans is notably low at 1.7% (using the Fitch Leveraged Loan Default Index) from 2016 to 2018 and 2% when looking at the 2004-2021 period.
Private credit funds and CLOs – a cautionary tale
We have seen the above dynamics impact our clients’ funds in both private debt and CLO space. Private loans and the underlying loans embedded in CLOs are not completely exempt from the inflationary pressures amidst the increasing rate environment. The analysis must account for the underlying sector associated with each borrower and their ability to pass-through price increases to their clients. Legacy positions have been the focus of a line-by-line examination of the ability of each borrower to pass-through price increases. An inability to do so resulted in some mark-downs in certain funds. In private debt space, E-Commerce was a sector that boomed after the pandemic, as online sales hit record highs across the globe. Many funds originated debt to E-Commerce companies in 2021, but supply-chain issues have caused dislocations in inventory management for many companies. In addition, consumer demand has waned in some pockets of this market, impacting E-Commerce revenues and margins. Within CLOs, we are seeing the weighted-average cash price of the loans reduce as a result. Some credit funds (loan and CLOs) have examined price dislocations of fixed coupon positions and some pools and have started to invest in such positions. The rationale being that large mark-downs in such assets are driven by rates rather than credit and this will stabilise in time, thereby improving par-building in CLOs. In terms of new issuance, within this environment many funds are shifting to more defensive sectors that are relatively immune from inflationary pressures.
Loans in FRN format benefit within the higher rate environment via the reference rate and therefore offer more stability in terms of cash price movement. Further security within loan transaction and CLO deals are 1) loans secured by collateral; 2) loans more senior in the stack, 3) amortisation paydown structure and 4) generally stronger docs and covenants as negotiated in ‘Risk-off’. All of which points to lower default rates of underlying loans in private credit and CLO space, however, private debt or CLO funds must also take into account the nature of the borrower, the sector, and their ability to pass-through pricing.
If you would like to find out more on this topic or discuss setting up a private loan fund, loan origination fund or CLO fund, please reach out to us directly.