Thinking ahead

Benjamin Franklin promised that only two things are certain in this world – death and taxes. For the last five years, some market observers may have thrown “low interest rates” in there as well.

Constructing a credit portfolio that is equipped to handle that normalization is essential. It’s heartening to see that some firms have taken the time to plan ahead

Just don’t count Apollo, KKR or Blackstone among them.

Franklin limited the now-famous axiom to death and taxes for good reason; the basement-level interest rates many took for granted over the last few years may become a thing of the past sooner than we’d expect. On Tuesday, Chicago Federal Reserve president Charles Evans said that the central bank might slow its asset-purchasing programme at some point later this year, assuming the US economy continues its strong recovery. A slowing rate of asset purchases would forecast an eventual rise in interest rates; something Fed Chairman Ben Bernanke said would be considered once the US unemployment rate drops below a 6.5 percent threshold.

Evans’ projection of when the Fed will adjust its policies is much sooner than that outlined by Bernanke earlier this year. As such, many market analysts have questioned the strength of large credit portfolios, particularly those of firms that may be locked up in fixed rate loans or securities (when interest rates go up, lenders assume a risk that the value of those loans and securities will decline). Floating rate loans – though typically associated with lower rates at the outset – transfer that risk to the borrower.

The leadership of each of the above firms has made no small claims about their credit businesses’ ability to withstand rising interest rates.

“We've been saying for a while that we think rates are going up, and we have positioned ourselves for that,” said Apollo president Marc Spilker during a second quarter earnings call Thursday. “The business tends to be bar belled where — $25 or so billion of our senior loan business — the majority of that is in floating rate instruments, which obviously have a lower duration.”

“And so not to say that we're immune. But we've structured the portfolios so that when rates go up, we were going to minimize any of the drawdowns … the majority of our funds still have positive performance even in light of the market moves in June.”

KKR has adopted a similar policy, according to statements made by head of global capital and asset management Scott Nuttall, and Blackstone’s Tony James went so far as to say that his firm has “essentially zero interest rate risk” in its credit portfolio during a second quarter earnings call.

The foresight demonstrated by the above firms has not been the case across the board. PDI spoke with at least one general partner who indicated that his firm’s investments remain locked up in fixed rate loans. If rates begin to creep back up faster than expected, that portfolio will be heavily exposed to interest rate risk.

As the breadth of opportunity in the credit space continues to grow, planning for unexpected turns in monetary policy will be crucial. Predicting the actions of the Fed based on statements to the press and hints may be seen as reading tealeaves, but interest rates have to go up eventually, and the Federal Reserve has grown evermore specific with its plans to eventually normalize interest rates.