Finance markets

Rising Inflation Poses Risks and Opportunities for Leveraged Financial Markets | White & Case LLP

For the first time in years, inflation is on the radar for lenders and borrowers of high yield bonds and leveraged loans, but what impact could this have on the markets?

A prolonged period of low interest rates and abundant liquidity have been the main drivers of leveraged finance activity in recent years, fueling investor demand for yield and a strong appetite for leveraged loans. and high yield bonds.

But as signs of rising inflation appear, the market is wondering if that can change and when. There are signs that lenders and leveraged borrowers may need to seriously consider the effects of inflation and the possibility of higher interest rates.

The combination of extensive government stimulus programs to tackle the economic impact of COVID-19 and the increase in savings thanks to the pandemic have built up large cash reserves. These are now pouring into economies as vaccinations are rolled out and restrictions are relaxed.

As a result, inflation has increased in all of the world’s major economies. In the United States, 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 hit a two-year high of 2% in May before falling to a still significant level of 1.9% in June. Meanwhile, in China, producer price inflation soared to 9% in May, its highest rate in more than 12 years. As the world’s largest supplier of goods, rising producer prices in China could push 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 need to act by reducing accommodative monetary policies and raising rates. of interest.

Leverage financial markets could respond in three potential ways if inflation continues to rise and interest rates rise.

1. A boost for leveraged loans

The leveraged loan markets are positioned to take advantage of the growing influx of investors in anticipation of rising interest rates. Leverage loans have variable rates, providing investors with better protection against rising interest rates than long-term fixed rate bonds.

Inflows by US retail investors into loan mutual funds and exchange-traded funds totaled US $ 13 billion in the second quarter of 2021, according to private markets manager Partners Group. This compares to outflows of around US $ 27 billion for all of 2020.

In terms of trends, leveraged loan issuance in North America and Western and Southern Europe nearly doubled from $ 265.4 billion in Q4 2020 to US $ 500.01 billion in the first quarter of 2021. Show of 949 billion US dollars in the first half of 2021 is up from $ 636.7 billion in the first half of 2020. In Asia-Pacific (excluding Japan) (APAC), leveraged lending activity increased from $ 16 billion to first semester 2020 at US $ 21.8 billion in the first half of 2021.

If central banks have yet to raise interest rates, this may reflect the fact that investors seem to have felt that loans will be the main beneficiaries in an environment of rising long-term interest rates.

2. Reaction of high yield bond markets in the balance

High yield bonds have offered investors an attractive investment proposition during the pandemic, shielding lenders from the volatility of stock markets and government bonds and offering attractive margins against other assets.

However, as economies reopen and growth increases, investor appetite for high yield bonds may react in anticipation of higher inflation and rising interest rates.

On the one hand, in the United States, for example, mutual funds and exchange-traded funds that buy high-yield U.S. bonds saw outflows of $ 5.6 billion in the six weeks leading up to early June, according to EPFR Global data, erasing the inflows that had accumulated since early November 2020. On the other hand, these outflows have not yet impacted high-yield issues. High yield bond issuance in North America and Western and Southern Europe hit a six-year high of US $ 373.8 billion in the first half of 2021, against 267.5 billion dollars recorded in the first half of 2020. In APAC, high yield issues increased from 45.1 billion dollars in the first half of 2020 to US $ 57.9 billion in the first half of 2021.

This suggests that retail investor reluctance has yet to take hold across the market as a whole, although investors and borrowers are watching central banks closely for any signs of tightening monetary policy.

In an inflationary environment, some high yield bond issuers may choose to accept shorter maturities to provide investors with protection against foreclosure of long-term fixed rate bonds, but also to ensure that they are able to conclude their business. These mounting inflationary pressures can also lead to revaluation and refinancing of existing debt, as companies try to avoid any nasty surprises as interest rates also start to climb.

3. Terms and documents will not change until interest rates do.

Although rising inflation and interest rates can drive up the cost of financing for borrowers and dampen lenders’ appetite for substandard debt, the terms and prices of debt financing agreements leverage is unlikely to change until there is a substantial change in interest rates.

Inflation and interest rates are now undoubtedly on the radar of investors and borrowers, with lenders modeling the potential impact of inflation on borrowers’ profitability and the ability to service debt.

But in an always competitive market, parties will continue to focus on the current climate rather than setting terms and prices speculatively. Indeed, it is believed that inflation will gradually moderate as consumers use up their cash reserves in the event of a pandemic, supply chain constraints ease, and governments lift support for the stimulus.

Inflation is also just one of many factors boosting debt markets, the high level of dry powder available to private credit funds is expected to continue to fuel activity even as inflation and interest rates decline. interest is increasing. Likewise, the ongoing costs of COVID-19 could prove to be of greater concern to markets than inflation.

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