From money managers at BlackRock and T. Rowe Price, to analysts at Goldman Sachs, to the credit shops run by Blackstone and KKR, a new economic reality is prompting Wall Street’s most powerful forces to adjust their investment strategies.
The rise in inflation set to accompany the post-pandemic economic boom is threatening to reverse the four-decade decline in U.S. interest rates, sparking a rush to protect the value of trillions of dollars of debt-market investments.
The first signs of this shift have already emerged: These firms and others are moving money into loans and notes that offer floating interest rates. Unlike the fixed payments on most conventional bonds, those on floating-rate debt go up as benchmark rates do, helping preserve their value.
“We’ve had a long 35 to 40 years of rate decline that has been a big support behind fixed-income investing, a big support behind equity multiples expanding, and so for those of us that live and breathe investing, it’s been a wind at our back for a long time,” said Dwight Scott, global head of credit at Blackstone, which manages $145 billion of corporate debt. “I don’t think we have the wind at our back anymore, but we don’t have the wind in our face yet. This is what the conversation on inflation is really about.”
To be clear, no one is predicting the type of rampant inflation the likes of which roiled the U.S. economy almost five decades ago. Yet a subtle shifting of the tide is already underway, many say.
Not since 2013, in the months before Federal Reserve Chairman Ben Bernanke triggered the so-called taper tantrum by suggesting the central bank could begin to slow the pace of monetary stimulus, have global bonds been under so much pressure to start the year.
Fueled by growing concern that price pressures are poised to reemerge amid an economic boom powered by vaccines, pent-up consumer demand and another round of government stimulus, 10-year Treasury yields have soared more than 0.4 percentage point.
Amid the upheaval, perhaps no market is attracting more attention than leveraged loans. Weekly flows into funds that buy that debt have already exceeded $1 billion three times this year—triggering fresh talk of froth—after having not topped that threshold since 2017.
The asset class’s relatively high yields make it an appealing investment for firms seeking to juice returns as the gap between Treasury rates and corporate debt narrows. At the same time, continued monetary and fiscal support from policy makers is expected to boost company earnings, helping them trim debt multiples that ballooned amid the pandemic.
Yet what makes leveraged loans especially attractive to many is their floating payment stream. As the long end of the Treasury curve continues its dramatic ascent, their lack of duration—or price sensitivity to moves in underlying rates—provides investors significant protection, even in an environment where the Fed keeps its policy rate near zero and the front-end anchored for years to come.
“You don’t buy leveraged loans today because you expect the floating rate component to go up,” said Lotfi Karoui, chief credit strategist at Goldman Sachs. “That is not the thesis. The floating rate component is going to stay flat for the foreseeable future. You buy it because the reflation theme is something that hurts more the high-yield bond market relative to the loan market.”
That’s not to say that junk bonds aren’t luring their fair share of cash too.
The asset class can often be a safe harbor from the threat of rising rates given that an improving macroeconomic backdrop tends to lower credit risk, allowing spreads to tighten.