A sustained period of low interest rates and abundant liquidity have been primary drivers of leveraged finance activity in recent years, fueling investor demand for yield and strong appetite for leveraged loans and high yield bonds.
But as signs of rising inflation emerge, the market is questioning whether this may change—and when. There are signs that leveraged finance lenders and borrowers may have to seriously factor in the effects of inflation and the possibility of higher interest rates.
The combination of vast government stimulus programs intended to combat the economic impact of COVID-19 and increased savings through the pandemic have seen a build-up of significant cash reserves. These are now flowing back into the economies as vaccinations are rolled out and restrictions ease.
As a consequence, inflation has been rising across all of the world’s major economies. In the US, consumer prices saw their largest increase in 13 years in June, with the consumer price index increasing 5.4% year-on-year. In Europe, inflation climbed to a two-year high of 2% in May before easing back to a still significant 1.9% in June. Meanwhile, in China, producer price inflation climbed to 9% in May–its highest rate in more than 12 years. As a major supplier of goods worldwide, rising producer prices in China could drive up inflation globally.
Some argue that this rise in inflation may have already peaked, but if high inflation persists, the International Monetary Fund (IMF) believes central banks will have to act by scaling back accommodative monetary policies and increasing interest rates.
There are three potential ways in which leveraged finance markets could react if inflation continues to rise and interest rates increase.
1. A boost for leveraged loans
Leveraged loan markets are positioned to benefit from rising investor inflows in anticipation of increasing interest rates. Leveraged loans have floating rates, giving investors greater protection from rising interest rates than long-duration, fixed rate bonds.
Inflows from US retail investors into loan mutual funds and exchange traded funds totaled US$13 billion in Q2 2021, according to private markets manager Partners Group. This compares to outflows of approximately US$27 billion for all of 2020.
In terms of trends, leveraged loan issuance in North America and Western and Southern Europe almost doubled from US$265.4 billion in Q4 2020 to US$500.01 billion in Q1 2021. Issuance of US$949 billion in H1 2021 was up year-on-year from US$636.7 billion in H1 2020. In Asia-Pacific (excluding Japan) (APAC), leveraged loan activity climbed from US$16 billion in H1 2020 to US$21.8 billion in H1 2021.
While central banks have not yet raised interest rates, this may reflect that investors appear to have taken the view that loans will be the primary beneficiaries in an environment where long-term interest rates move higher.
2. Reaction of high yield bond markets in the balance
High yield bonds offered investors an attractive investment proposition during the pandemic, sheltering backers from stock market and government bond volatility and providing attractive margins, relative to other assets.
As economies reopen and growth surges, however, investor appetite for high yield bonds may react in anticipation of higher inflation and rising interest rates.
On the one hand, in the US, for example, mutual and exchange traded funds that buy US high yield bonds saw outflows of US$5.6 billion in the six weeks leading up to the beginning of June, according to data from EPFR Global, erasing inflows that had accumulated from the start of November 2020. On the other hand, these outflows have yet to impact high yield issuance. High yield bond issuance in North America and Western and Southern Europe climbed to a six-year high of US$373.8 billion in the first half of 2021, up from US$267.5 billion recorded in H1 2020. In APAC, high yield issuance climbed from US$45.1 billion in H1 2020 to US$57.9 billion in H1 2021.
This suggests that retail investor skittishness has yet to take hold across the entire market, although investors and borrowers are closely watching central banks for any signs of monetary policy tightening.
In an inflationary environment, some high yield bond issuers may opt to accept shorter maturities to offer investors protection against being locked into long-term fixed rate bonds, but also to ensure they are able to get their deals away. These growing inflationary pressures may also lead to a push to reprice and refinance existing debt, as businesses try to avoid any unpleasant surprises as interest rates begin to climb as well.
3. Terms and documents will not change–until interest rates do
Although rising inflation and interest rates could drive up the cost of financing for borrowers and dampen lender appetite for non-investment grade debt, terms and pricing in leveraged finance deals are unlikely to change until there is a substantial shift in interest rates.
Inflation and interest rates are now undoubtedly on investor and borrower radars, with lenders modeling the potential impact of inflation on borrower profitability and the ability to service debt.
But in a still competitive market, parties will continue to focus on the current climate rather than set terms and pricing speculatively. Indeed, there is a view that inflation will gradually moderate as consumers work through pandemic cash reserves, supply chain constraints ease and governments unwind stimulus support.
Inflation is also only one of many factors driving debt markets, with the high level of dry powder available to private credit funds expected to continue fueling activity even if inflation and interest rates do increase. Similarly, ongoing costs related to COVID-19 could prove a bigger concern for markets than inflation.