Fed unwind unlikely to upend private credit

Should private credit encounter turbulence, it likely will not be from the actions of the US central banks.


Though not unexpected, many in the private debt world are wondering what the Fed’s pivot away from the road map it has followed since the global financial crisis could spell for a mid-market credit cycle nine years into a recovery.

Will the Fed’s selling its balance sheet – which had reached $4.5 trillion as of September – along with raising rates spell trouble for private debt? Not so, say some experts in the field who think the Fed’s move may bode well for private credit.

This month, the Fed began its “balance sheet normalisation programme” to gradually sell-off of its securities, which the central bank drew up in June, shedding off a maximum of $6 billion in Treasuries per month and $4 billion in agency securities per month through the rest of 2017.

This move lays to rest the monetary policy the US central bank had followed since 2008, which it enacted to spur liquidity and economic growth in response to the global financial crisis. In addition, the Fed maintained interest rates for US Treasuries at their current 1 percent to 1.25 percent range, but signalled a potential future interest rate of up to 2 percent.

And at least for the overall non-investment grade corporate credit space, the Fed’s gradual unwinding of its balance sheet and eventual raising of interest rates will likely be a boon to private credit, Jack Yang, Alcentra’s head of the Americas and global head of business development, said last month.

“We expect this to basically be a great thing for our markets within reason,” he said during a Bank of New York Mellon media luncheon on 20 September, the day the Fed announced the balance sheet normalisation plan would start October.

The historical research on performance data show that non-investment grade credit has consistently performed well six months after an interest rate increase. This is due to the improving economic conditions concomitant with rate hikes and the general short duration, floating rate nature of private credit investments, Yang added.

If anything, the Fed’s measured and transparent approach to shrinking its balance sheet has made debt managers comfortable, Randy Schwimmer, senior managing director and head of origination and capital markets at Churchill Asset Management, told Private Debt Investor.

“What the Fed got right is signalling markets early on when considering policy changes,” Schwimmer said, a lesson learned from the so-called “Taper Tantrum” four years ago, when a Fed announcement of plans to taper its $70 billion-a-month bond-buying programme caused a panic sale in US Treasuries that surged interest rates higher.

“The Fed’s stable monetary policy allows private credit managers to focus on other things,” Schwimmer explained.

He added that there is a general expectation among private debt managers that the Fed’s ultimate end target will not require going back to a pre-crisis level balance sheet, therefore the market already has an inkling as to how many Fed securities private investors will have to absorb.

Deutsche Bank, too, doubts that the Fed’s decision – though a “defining moment in the post-crisis era” – will necessarily precipitate danger in the global credit markets, according to a report the global financial firm released last week.

The report titled “Can markets withstand the removal of QE?” notes that many in the credit world have sounded the downturn alarm recently because of the significant rise in the equity markets – the S&P 500 has quadrupled since 2009 – coupled with a lowering cost of debt.

“As borrowing costs for companies have continued falling over the past decade, warnings about impending disaster have become ever louder,” the report noted.

But this equity rally and borrower-friendly market has not depended on the Fed buying up securities and keeping interest rates low, the report argued. It has more to do with the strong performance and relative attractiveness of US companies, good news for private credit investors as much of the money raised for the asset class is North America-focused.

Oil prices have recovered since they dropped precipitously in 2014, and as a result, US company defaults have declined substantially, the report highlighted. The US default rate over the 12 months preceding October was 3.6 percent, and Moody’s forecasts it will fall to 2.6 percent over the coming year.

On top of strong fundamentals, US companies have been more disciplined as far as maintaining a healthy debt-to-equity or debt-to-EBITDA ratio, compared to the pre-crisis years, according to the report.

“Investors can, therefore, have some confidence that corporate America is healthy enough to withstand the QE unwind,” the report concluded.