8 min read 31 Jan 22
The jury may be (currently) out as to whether rising consumer prices are temporary or permanent, but the return of inflation is rattling markets and policymakers alike. This is in spite of several headwinds, including rising virus infection rates as Omicron spreads at rapid-pace, along with rising energy costs, global supply chain imbalances and labour shortages, that have emerged and threatened to curtail renewed growth momentum.
Most developed markets at least, haven’t really experienced prolonged inflation since the 1970s (barring a brief spell in the early 1990s) – in the decades that preceded this period, inflation printed at around 2-3% a year, for the most part.
For many asset owners, like pension schemes, inflation is viewed from a risk perspective. The impact of inflation on pension liabilities will ultimately vary for each scheme and depend partly on level of inflation hedging already in place, as well as the way in which pension benefits are linked to inflation. Schemes with a lot of inflation-linked liabilities that are not fully hedged (realised inflation also being hard to predict with precision) could see a greater increase in the present value of their liabilities relative to assets amid higher inflation – creating potential balance sheet risks. Certainly, there could be cashflow challenges posed by inflation for defined benefit schemes closed to future accruals given many are already cashflow negative.
Whether current inflation will prove to be prolonged, how can asset owners ensure they effectively hedge against inflation risk? While a perfect (and costless) ‘hedge’ does not exist, there are several ways in which to hedge in more inflationary environments, beyond employing explicit, dynamic hedging strategies – largely by focusing on asset classes typically less affected by inflation or gaining exposure to assets which tend to rise in value in inflationary environments.
Maybe they could directly invest in inflation-linked instruments, like inflation-linked government bonds, that are designed to hedge against inflation or diversify into areas of credit potentially offering positive returns above the risk-free cash rate. Globally, demand for inflation-linked government debt far outstrips the current supply of these instruments – in some countries, governments do not issue inflation-linked bonds – to enable pension schemes to match their inflation-linked liabilities, and valuations tend to be high.
As a result of this shortfall, asset owners may look to other traditional, indirect inflation ‘hedges’ and asset classes whose investment returns have historically tended to stay ahead of longer-term inflation (or at least keep pace with it), including real assets investments backed by hard, tangible assets like unlisted real estate or infrastructure. The degree varies depending on the nature of the investment or underlying asset – exposure to sectors and companies that are positioned to benefit during an inflationary environment, or through a structure that delivers a close, positive correlation with inflation.
Commodities, particularly precious metals like gold have long been lauded as ‘effective’ hedges against inflation over the long term, but gold ended 2021 pretty much flat on the year despite inflation concerns dominating for much of it. Demand for gold also tends to be speculative and is therefore subject to bouts of volatility, and importantly, the precious metal does not generate income streams.
For those looking to mitigate against inflation risk and generate relatively stable cashflows, could short-dated private and illiquid credit be utilised in portfolios as a ‘hedge’?
The modus operandi of central banks to counter runaway consumer prices has typically been to raise short-term interest rates. The asset class could therefore potentially offer relative return and income protection against an environment of rising rates and inflation, largely due to its short duration characteristics and variable-rate coupon structure – and typically attractive spreads on offer.
Central banks have already switched to monetary tightening mode. Inflationary pressures forced the Bank of England to pre-emptively act by raising rates to 0.25% in December, after headline inflation in the UK printed at a decade-high. The US Federal Reserve (Fed) has also shifted to a more hawkish stance after inflation rose at its fastest pace in three-decades, by projecting three 25 basis point (bp) interest rate rises in 2022 and signalling that it will double the pace of its tapering which is set to come to an end in March.
In Europe, the inflationary backdrop is slightly different to the US and the UK, although Eurozone consumer prices are running well above target. The European Central Bank (ECB) has previously pressed back against market expectations that rate increases could begin as early as the second half of 2022. Nevertheless, markets are dialling up their bets that the ECB too could be forced to lift interest rates in order to tame surging inflation should price rises prove stickier, and thus less transitory, than currently expected.
This new reality of higher inflation and remedial rate hikes has prompted asset owners to look at their current fixed income allocations and re-assess whether the level of risk protection offered by their portfolios is sufficient to earn the investment returns needed to meet their targets. Core fixed income allocations comprised mainly of traditional fixed income holdings (government bonds, investment grade (IG) corporate credit assets) which typically pay a fixed-rate cash coupon – so the value of fixed income and returns generated from these holdings will be susceptible to interest rate changes.
It also stands to reason that holding fixed-rate instruments could be a loss-making prospect in real terms, given the value of investment returns will be eroded by inflation over time especially for those assets with tight spreads and high asset valuations at the time of purchase; which would mean they would earn lower real returns than other assets potentially offering more of a protective buffer against the erosive effects of inflation and rising rates, respectively.
In the current low-yield environment, asset owners have found income generation from traditional fixed income assets harder to come by. For some, this has incentivised them to look further down the credit spectrum for yield (thereby increasing credit risk), or take on more duration risk (thereby increasing interest rate sensitivity) by investing in longer-dated assets in a bid to increase returns. However, its well-understood that increasing duration risk is an undesirable option in a scenario of rising interest rates.
Allocating more to higher-returning, floating-rate assets, including those found in the short-dated private credit universe, could be one way to minimise the interest rate sensitivity of fixed income portfolios and shield against inflation risk, while at the same time increasing returns.
Over the years, institutional asset owners have primarily looked to the short-dated private and illiquid credit universe for yield pick-up and diversification of risk to help them achieve their return targets as well as reliable income streams to help meet current liabilities. They may also view the asset class as a means of reducing overall duration in a blended credit portfolio. This is because many shorter-dated private credit investments, both on the corporate debt (for example, senior-secured leveraged loans) and non-corporate/structured finance side (for example, asset-backed securities (ABS), significant risk transfer (SRT) trades, consumer finance), are very low duration and pay a floating-rate coupon that adjusts with changes in interest rates.
Investing in ‘high carry, low duration’ private credit assets could potentially offer several advantages over other fixed income assets and instruments, without having to take on significant investment risk. The spreads typically on offer are particularly compelling for the associated credit risk, in our view, while still maintaining underlying credit quality.
In-built defences to rising rates: In a rising interest rate environment, the case for investing in short-dated private credit asset classes should be revisited in our view. The floating-rate mechanism enables the coupons to adjust higher in short intervals, based on underlying changes in the short-term reference rate such as SONIA, Euribor or SOFR, typically resetting every three months (90 days), which means they have a near-zero duration. So not only does investment in these assets pose minimal interest rate risk to a portfolio, but are designed to benefit in a scenario of rising rates – without resulting in a funding drag that would arise from having to hold collateral for hedging purposes. As the underlying short-term reference rate rises, so does the coupon income paid on the loan.
High running income potential: In an environment of low and flat yields, these private credit asset classes could offer reliable, high running coupon income. In loans, income-driven returns are enhanced by the presence of zero-minimum rate-fixing floors (worth an additional c.50 basis points (bps)). Direct lending, whether structured as traditional cashflow lending or asset-based lending (ABL) transactions, have the potential to generate higher risk-adjusted returns. This is because these assets typically offer an ‘illiquidity’ or ‘complexity’ premium to compensate for the lack of secondary trading opportunities, and involve bespoke structuring tailored to the borrower’s needs. In this way, illiquidity and complexity can be sources of extra return for asset owners that can comfortably accommodate a degree of illiquidity due to the nature of their liabilities.
Real estate debt investments can be structured with floating-rate interest rates, with loan interest paid from rental income generated by the underlying commercial property. Floating-rate European ABS markets also provide opportunities for yield pick-up, given their positive carry characteristics with lower asset volatility than public market equivalents – generated from simply collecting the coupons of the assets until maturity.
Diversification potential: In addition to being a potential source of yield, adding private credit is widely considered to provide risk diversification, especially for portfolios comprised mainly of widely-traded (corporate) bonds. Private assets tend to have very different underlying risks and performance drivers, with this particularly the case for real assets and consumer finance, or esoteric assets where public market comparators simply don’t exist. Private credit can also provide issuer diversification given the majority of private issuers are not active in public markets. For example, there is limited crossover between loan and high yield bond issuers in Europe, and ‘mid-market’ corporate direct lending tends to involve lending to private businesses with EBITDA typically in the range of €10-40 million, according to our definition – too small to access the public capital markets.
We expect ‘high carry, low duration’ private credit to flourish with institutional investors. An attractive level of carry ought to be in high demand as fixed income investors fret over tight spreads and high asset valuations; the impact of inflation; and remedial rate-hikes. It is worth noting that these are areas of the private credit universe that are benefiting from technical tailwinds including robust supply dynamics, and are underpinned by solid market fundamentals with default rates remaining low in Europe.
Nevertheless, risk mitigation even in floating-rate, senior secured private lending inherently relies on strong underwriting and careful stock selection. Private lenders that focus on the quality of credit underwriting and proactive risk management and mitigation can help to build greater resilience into portfolios amid changing conditions.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.