Interest rates and recession: key risk factors for credit funds

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 circa 4.5%), inflationary pressures will be the main decision-driver for the Fed. However, as recession looms in the US, the Fed may include growth and unemployment in their forward guidance. 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.

Hikes in Europe were further stifled due to a fragmented response across the Continent due to Covid-19 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 rates currently at 2.5%, more hikes in Europe are expected as inflation prints persist. 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.

Company level

On the assets side, metrics such as Free-Cashflow, are important to consider as it represents the available cash used to pay interest and debt. Sales and revenue report how successful the company is at selling their goods/services. In a high-inflationary environment, the company is exposed to price increases and must be able to pass-on such increases to end clients. During a recession, as demand decreases, revenues are impacted, which negatively impacts free-cashflow. In this situation a company must decrease costs to account for a reduction in revenue and may start to row back on new investment projects, long-term contract commitments and focus on hiring freezes or staff reduction.

On the liabilities side of the company, debt outstanding gives a snapshot of future liabilities, interest rates charged on the debt (also called coupons), the use of proceeds and when the debt is due. The maturity profile is important to determine if all debt is due on the same date, thereby elevating credit risk concerns. As the debt matures, the company must renegotiate new terms, which may increase or decrease interest rate payments, namely refinancing risk.¹ Typically, in a high-inflationary environment, companies can pass-through price hikes to clients to accommodate additional debt interest expense. An inability to do so, erodes free-cashflow. Many companies are now faced with refinancing risk as legacy debt with low interest payments become due, to reissue new debt causes the interest payment to be considerably higher. A company with no cash on hand to pay interest or repay debt will be in breach of covenants and will be classified as being in default.

Sector implications

In the 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 company inventory management. In addition, consumer demand has waned in some pockets of this market, impacting E-Commerce revenues and margins. We have seen a dramatic shift of consumer behaviour to reduce online shopping and increase footfall in shops. Thus, E-Commerce investments are under pressure as revenues have suffered. Adding in a potential recession as a factor, many investment managers have also shifted to defensive portfolios by investing in healthcare and non-cyclicals – similar to the actions of investment managers during the pandemic.

Dynamics in the loan and CLO market

We are seeing a removal of investment banks from the direct lending markets in the US and Europe. This offers an opportunity for funds to originate loans directly to companies.² As debt is downgraded by the Rating Agencies, the asset class becomes expensive to hold on balance sheet and banks step out of the market, paving the way for funds to originate directly to companies. Managers in loan space are maintaining discipline in building more pristine funds as the borrowing terms have switched in favour of the lender – implying that managers are more selective in this market. Thus, the focus remains on more non-cyclical, defensive sectors. More cyclical sectors will be priced wider as a result, in the short term.

Private loans and the underlying loans embedded in CLOs are not exempt from the inflationary pressures within an increasing rate environment. Some credit funds (loan and CLOs) have examined price dislocations of fixed coupon positions (interest rate) 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 stabilising 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.

Since the GFC, the global economy has been exposed to events in financial markets as businesses were impacted by systemic risk linked to ill-fated investments in complex financial instruments, impacting investor confidence. The credit risk profile of all bonds in these countries increased dramatically as a left-leaning government³ has a higher probability of burning bondholders. The GFC, Covid-19 and political risk all serve to impact companies offering goods/services in the same ways. As consumer sentiment dissipates on the back of negative news stories, companies cash generation declines with demand. The cost of refinancing debt increases as investor sentiment declines, banks reduce lending and the expected return (increased credit risk) is elevated. Regarding interest rates, monetary policy setting is not as straight-forward as that of the US for example, given multiple countries involved, therefore a lagged effect is seen between the two jurisdictions. The war in Ukraine has the potential to generate more volatility in Europe, through higher commodity prices, shipping delays etc, all of which could be exacerbated by European or global recession. As discussed earlier, the ability of borrowers to pass-through price hikes has been crucial to company performance. Within an economy hit with either stagflation or recession, European companies may not be as nimble as US companies to adopt such an approach. Table 1 below summarises the key risks, categorised as risk impact within the two jurisdictions.

The past 12 months have seen assets in general being hit with consistent volatility, as discussed earlier. As a results of Waystone’s experience in the market, during this period we have seen considerable drawback from investors. There are several risks prevailing (e.g. war in Ukraine, lockdowns, supply chain issues, inflation and rates) but new risks have emerged (e.g. risk of recession) to put investors on alert. During 2022, investors were reluctant to commit capital to funds in Europe, in particular, for the reasons cited above. In addition, currency volatility has played its part in guiding investors to other geographies. Within a high-volatility market, asset value declines are common, thereby reducing liquidity further.⁴ This may serve to hold up fund launches if investors decide to shelve projects and maintain dry powder for instance. Existing funds in credit space have also suffered markdowns throughout 2022. Some of the markdowns are related to assets that needed to be restructured and some are related to any fixed coupon positions within funds (as a function of inflation/higher rates). The latter has also curbed the growth of existing credit funds.

CLOs have seen equity tranches marked down considerably, as they are further down in the note structure. Given the dearth of investor in European CLO markets, any shift in focus away from equity, has a profound impact on liquid and valuations. The CLO market is driven by eligible collateral of private credit – if a loan is eligible for CLOs, it is more liquid and has a more stable mark. In addition, as rates increased, many investors moved away from mezzanine and equity CLOs into seniors, thereby causing a large markdown in equity tranches.

Senior secured floating-rate note (FRN) coupons

Investors have weighed up their options in a high interest rate environment as they consider stable cashflows from coupons that offer some element of downside protection. From Waystone’s experience, the vast client base is predominately within direct lending to mid-cap within Floating Rate Notes (FRNs). The FRN format of the loan is set up in order that the reference rate (now SOFR in the US) 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 remainder recycled into new investments.

Loan security

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. In the case where the borrower struggles to repay principal or interest on the loan, investment managers work closely with borrowers to remedy covenants, restructure payments or tweak operations. If the company fails to recover, the collateral may be examined to cover the amount of the loan – with senior creditors paid first in terms of priority. 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.

Company strategy

Despite the loan market being exposed to a variety of macroeconomic and microeconomic risk factors, there are a number of mitigants to offsets such risks. In a credit squeeze firms will need to try to protect their free cash flow in order to avoid the need to raise expense debt finance or investor equity. To do this, companies focus on costs. Many firms may also opt to cut dividends to maintain equity within the business and in addition capital investment projects may need to be postponed. Within this environment, we see some companies take over non-cyclical IT or healthcare companies to offer cash generation as the business cycle contracts. Companies must have some flexibility in terms of price setting and have the ability to pass-on price increases to clients in order to present cash.

The role of the sponsor

Away from Europe, US credit funds have continued to deploy capital in private credit markets but in small sizes. In addition, the role of the sponsor is now an essential requirement for such funds looking to deploy capital as the threat of recession looms. US funds have shown their flexibility during and within the aftermath of Covid-19 and this flexibility is maintained as IMs become more cautious in deploying capital. In-depth deal screening and defensive sectoral focus have become vital to IMs. Covid-19 has also shown that sponsors are more willing to work with companies through a crisis to re-organise the management, offer payment holidays (for a cost!), restructure covenants and input equity to help restore the company to profit.

Optimise debt

The role of debt is an important consideration with many firms, post Covid-19, burdened with high debt levels. As previously mentioned, many will struggle with refinancing risk within a rising interest rate environment. To circumvent refinancing risks, it is important to understand the stage in the credit cycle and liability profile of a company. Locking in long-term debt at cheap rates is one way to reduce refinancing risk, especially if the use of proceeds is for short term needs. To alleviate concerns about repayment of debt, a company should smooth out its debt maturity profile to avoid the debt-wall scenario. When offering new debt to the market, a company is faced with the prospect of better debt terms (lower rates, reduced covenants) in the good times versus strict debt terms (higher rates, strict covenants) in the bad times, similar to the post Covid-19 period. To mitigate, the company must be nimble and strategic enough to look to refinance expensive debt and renegotiate better terms at opportune periods of the credit cycle. We have seen many companies already opportunistically tapping bond markets (Q1 2023) in risk-on periods to lock in long-term financing at lower levels.