Watch out for the rates tsunami

The leveraged loan boom has been partly fuelled by the central bank-driven low interest rate environment. What happens when the tide turns?

In a PDI video this week, Jake Lee of Korean LP Hyundai Marine & Fire Insurance, paints a picture of the impact of US interest rate rises on his organisation’s strategic approach. He thinks that, if you’re looking at senior secured investment based on a 4 percent return, you can lose 150-200 basis points on day one. For Lee, that simply doesn’t make the US market attractive any more.

The direction of travel on US interest rates is clear, with at least two more hikes expected this year –June and September are tipped as the most likely months – to add to the one in March. However, on the back of strong economic growth, there is an increasing expectation of four interest rate rises rather than three – with the last to come in December. A month ago, the Federal Funds Futures market measured the possibility of this at 33 percent. Now it believes there’s a 50 percent chance.

A recent report from S&P Global – Leveraged Finance: Will the Worst Deals be Done in the Best of Times, Again? – points out that asset values and leveraged transactions have benefited enormously from the fact substantially lower interest rates have prevailed since the global financial crisis, driven by quantitative easing from central banks. However, there are now strong inflationary pressures, resulting in the stock market volatility seen earlier this year.

Some see this volatility as the tip of iceberg, given the possibility of faster and more significant rate rises and their impact on asset valuations, debt returns and recovery expectations over the coming months and years. In the view of the S&P report, “as the credit cycle peaks, lenders are becoming more vulnerable to a sudden, sustained turn in risk appetite and tightening credit conditions”.

What past S&P research has shown is that default rates tend to bump along the bottom for many years before suddenly spiking when conditions toughen. It fears that in the current environment many companies that would have struggled in more normal times have taken advantage of the abundance of cheap capital to prolong their survival. But as the cycle turns and refinancing becomes much more difficult, we might expect that default rate to climb rapidly upwards.

And that is why an LP like Lee is already acting in the face of what appears to be a material change in circumstances. Expect others to be similarly assessing their exposure to the US and whether the time is right to head for the hills before a destructive wave hits the shore.

Contact the author at andy.t@peimedia.com.