Credit cycle turns as war in Ukraine adds to inflation fears

Earlier this month, a US prison food supplier offered a deal that contained all the hallmarks of a frothy debt market. TKC Holdings had struggled to take on debt last year, penalized by more socially responsible investors reluctant to finance the prison industry.

Without a phase, TKC returned this year to investors seeking to raise $305 million, to fund a payout to its private equity owner HIG Capital, according to reports from the ratings agency and people familiar with the process. OK.

The deal was launched with a huge coupon of 12%, rising to 13.5% if the company chose to defer interest payments – a feature known as payment-in-kind or “PIK” and a signal of warning for credit investors wary of a company’s ability to pay its debts. So, did they have trouble closing the deal? No. It was raised to $320 million, suggesting strong investor demand.

As investors worried about inflation, which weighs on the value of stocks and corporate bonds, leveraged loans proved more resilient.

Other companies, such as Apollo-backed pharmaceutical company Covis, Brookfield-owned Scientific Games, or gaming company Golden Nugget, have struggled to stir up the appetite for bond deals, shifting funding to the loan market where investors have been more receptive.

The diverging fortunes of the two markets indicate their different sensitivity to inflationary pressures and changes in interest rates.

The interest rate paid to investors in a leveraged loan rises and falls with benchmark rates. Meanwhile, fixed rate bonds lose value as interest rates rise and new bonds with a higher rate of return come to market. As the U.S. Federal Reserve prepares to raise interest rates in March, investors have withdrawn billions of dollars from funds that buy U.S. high-yield bonds so far this year and poured cash in funds that buy US leveraged loans.

For now, that says more about the different amounts of money used to price bonds and loans than it does about the likelihood that US companies will be able to pay their debts.

The TKC deal showed that investors remain optimistic about risky corporate lending – especially when there is a lot of interest to be gained – even as they worry about the impact of more monetary policy. strict.

While investors have raised their expectations of future interest rates, raising corporate borrowing costs, they have not radically changed their pricing of corporate lending risk, expressed as the difference between corporate and risk-free bond yields. American treasures.

Economic growth is intact. Default rates should remain low. Corporate earnings remain strong. So far, the selloff in credit markets has been more about the expected path of interest rates than rising credit risk.

This week, that started to change. As rockets were launched and tanks crossed the Ukrainian border, oil prices rose above $100 for the first time since 2014. Russia is a big exporter of oil and the crisis could limit that supply, pushing up prices. price.

Oil prices are an important input in inflation measures. Core 10-year inflation rates, a market measure of inflation expectations, jumped nearly 0.2 percentage points for the week to Thursday. Rising oil prices are also having an impact, increasing costs for businesses and pushing them to raise prices themselves. There could also be further supply chain disruptions due to the crisis, which would further impact inflation measures.

The Fed has already tried to walk a tightrope between being hawkish enough to signal it is serious about fighting inflation, but not so hawkish that it risks raising fears of slowing economic growth. The unfolding crisis in Europe amplifies the latter’s risk, and slowing growth could mean that a sell-off is mostly limited to interest rates and threatens corporate credit.

The average price of US leveraged loans in a widely watched index slipped to its lowest level since August this week. US high-yield credit spreads, which measure the difference in yield between corporate bonds and US Treasuries, also rose, indicating a slow increase in credit risk.

This is partly due to a more technical reaction from the financial markets. As investors withdrew money from high-yield bond funds, these funds had to sell corporate bonds, pushing yields higher. Although different, corporate bonds and loans are both based on the risk of lending to a company, keeping their prices somewhat related to each other.

Some investors also said they saw loans sold in favor of cheaper – but broadly similar – bonds, driving down loan prices. But others on Wall Street argue that price moves aren’t just a technical reaction. As the Russian offensive intensified this week, sentiment in credit markets began to shift.

Some investors are increasingly worried about the conflict, what it means for the U.S. economic outlook and, ultimately, whether it’s enough to turn worries about rising prices into worries about corporate credit.

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