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Talking point: What happens to loans in an age of inflation?

UK economic data has produced something of a shock, highlighting the need for private debt managers to consider the consequences of changed circumstances.

The leap in UK inflation announced by the Bank of England, from 2 percent in July to 3.2 percent in August, will have generated much interest among those looking for signs of a forthcoming inflationary environment. It was the biggest monthly rise in the UK for almost a decade.

The cover story of our October 2021 issue explored what inflation might mean for the private debt market. Not everything we heard was encouraging.

Emmanuel Deblanc, head of private markets at Allianz Global Investors, may have spoken before the BoE’s announcement but could almost have had the UK data in mind when he told us: “As rates increase, will that stress the servicing of the debt? The big challenge for lenders would be if there was a sudden shock and change in the inflation paradigm.”

Paradigm shift

Deblanc’s reference to a paradigm change speaks to the second big question about inflation. The first is: will it happen? The second: how long will it last?

“Investor faith in the asset class remains strong”

Some think there could be a danger of overreacting if inflation proves to be only temporary. It is worth keeping in mind, after all, that alternative investments, including loans, are generally long term in nature and thus well placed to ride out short-term economic adjustments.

On the other hand, should inflation be a game changer for the market, there are plenty who say private debt has nothing to be afraid of. Reasons for this include the floating rate nature of many loans, which should protect them from interest rate increases and mitigate any impact on returns.

There is also a sense that private debt has demonstrated a resilience through the coronavirus pandemic that no one was entirely sure it possessed, given that economic tailwinds largely assisted the preceding period.

An Adams Street Partners report published in September 2021 revealed that private credit yields were around 270 to 300 basis points higher than those available for comparable investment options such as the high yield and leveraged loan markets.

It is unsurprising, perhaps, then that investor faith in the private debt asset class remains strong.