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What might rate cuts mean for the debt market?

22 May 2024

Please note: The article does not constitute advice or any form of investment recommendation. All numbers quoted were sourced from Bloomberg data as at Tuesday 21 May 2024.

As we head towards the second half of the year, and as leading central banks gear up for interest rate cuts, investors continue to argue over when rates will come down. While a lot of time and energy is spent on trying to guess which month the US Federal Reserve (Fed) will start to trim rates, little focus is placed on the likely magnitude of the upcoming cutting cycle. Yet, this is arguably much more relevant to the value of investors’ portfolios, along with the economic outlook.

Based on current forecasts and central bank messaging, interest rates should be lower in 12 months’ time as both growth and inflation moderate in key economies. However, the “cost of money” is likely to stay elevated relative to that seen over the last decade. Should the global economy slow faster than anticipated, interest rates could drop quickly. However, were this to be the case, the growth outlook will probably have worsened, upping pressure on the income streams that are needed to service debt.

This would mean that companies and households face higher financing costs − whether it’s in absolute terms or relative to their earnings. In turn, those borrowers who haven’t been prudent in managing their leverage since the COVID-19 pandemic could come under significant pressure. Such an environment would likely increase volatility, and potentially create investor opportunities as pockets of short-term financial stress emerge.

Debt market becoming more popular

The global high yield and leveraged loans market has more than doubled in size since 2008, and is currently valued at close to $4 trillion. Part of this surge can be attributed to the relentless “search for yield” that has pushed fixed income investors to search ever lower on companies’ capital structures to find sufficient income. It’s also the result of a decade of ultra-accommodative monetary policies that have made leverage a cheap way for management teams to boost returns.

With credit spreads tightening to historically low levels, it has been fairly easy to generate attractive returns in the high yield space. Indeed, the combination of resilient economic growth and low interest rates is a “Goldilocks scenario” for this part of the fixed income market. The fact that central banks started hiking rates a couple of years ago hasn’t been much of a headwind either, as leveraged loans tend to have floating rates. 

But does a day of reckoning beckon?

However, the macroeconomic environment is changing which in turn calls for investors to rethink their approach to the asset class.

Indeed, this collective pile of debt issued by companies with lower credit credentials − the majority of which is due for repayment in the next few years − could face a reckoning if interest rates stay higher for longer and top-line growth slows. A wave of restructurings could follow with, eventually, some liquidations. 

While a traditional fixed income investor might strive to avoid such a market, it also represents a significant source of opportunities for those able and willing to stomach the risk. 

What might this mean for the risk-reward profile?

While lower rates will result in a downward adjustment to floating rate debt, this could be more than offset by an improvement in borrowers’ ability to repay debt, which should lower the risk for investors. The result is a still attractive risk-reward profile, despite lower headline yields. Needless-to-say, risks should always be viewed in their entirety before any investment decisions are taken. 

At the same time, lower growth will help differentiate between companies that have a sound business model and those that don’t.  The latter will likely struggle to face their obligations to creditors, offering possible distressed opportunities. Indeed, such openings can be rewarding for investors who can navigate the process of debt restructuring. It will also allow short-sellers to profit when the situation lends itself to such a strategy.

Adapting to changing economic times

Clearly, investing in the leveraged loan market is a risky business that should be left to professionals with deep expertise in this field. It's also important to favour an holistic approach that can benefit on both the long and the short side. For those investors who can strike the balance between risk and reward, this is an asset class that may be worth considering given the macroeconomic environment we expect to experience in the near future.

At the time of writing, the European Central Bank and the Bank of England are expected to start trimming their respective policy rates this summer. The Fed is forecasted to make its first move later in the year, potentially in September. 

Please note: Our Mid-Year Outlook report publishes on 10 June 2024, on the Insights section of this website.

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