Belal Al Bonni, Senior Manager in Audit & Assurance at Deloitte Guernsey, takes a look at how debt managers are responding to a period of uncertainties – and the implications for investors
The world is experiencing a sharp increase in inflation rates, with Covid-related supply shortages and the turmoil of the energy market being cited as two key contributors to the rises.
Monetary policies have been tightened across the world, and the collateralised loan obligation (CLO) market, as well as the stock market, have witnessed a deterioration in prices over the past several months. So are we experiencing ‘the period of uncertainties’?
The mantra in financial markets for the past 40 years has been ‘don’t fight the Fed’. Currently, the US market is experiencing the biggest interest rate rise in almost 30 years; Australia, India and many other countries have similar instances of rising interest rates; and the European Central Bank is not immune.
On 22 June, the Bank of England stated: “Since December 2021, we’ve increased our key interest rate, Bank Rate, from 0.1% to 1.25%.” So is the ‘easy money’ period coming to end?
How has the debt market responded to these uncertainties?
The debt market continued to perform strongly in the post-Covid-19 recovery period – during the fourth quarter of 2021 through to early February 2022, when these uncertainties started to crystallise.
The European corporate bond market had a strong performance during 2021, with 1,322 deals being closed with an aggregate value of more than €800bn.
This was also the theme for January 2022, when fundraising exceeded the same month in 2021.
However, in February 2022 there was a significant drop in fundraising activities, followed by a swift rebound post-February, with a shift in the type of debt instruments from high-yield to investment grade as a short-term response to the uncertainties.
The private debt sector had a similar experience, with very strong fundraising activities during 2021. Like the bond market, there was a deterioration on fundraising activities during the first quarter of 2022.
However, Preqin predicts that private debt assets under management will rise to $2.69trn by 2026, achieving a compound annual growth rate of 17.4%. This would make private debt the fastest growing asset in private capital.
How have debt managers responded to such uncertainties?
During a rising interest rate environment, savings products such as high-yield savings accounts or certificates of deposit might look more attractive to risk-neutral and risk-averse investors.
In contrast, investors seeking more risk/return would require higher returns to compensate for the level of risk taken on top of maintaining the real value of their investments.
As witnessed in European corporate bond market activities, there was a shift in fundraising activities during the current period toward investment grade bonds and less on the high-yield bonds.
But will this shift be for the short term or the longer term?
Inflation is most damaging to the value of fixed rate debt instruments because it devalues interest rate payments as well as repayments of the principal. If inflation exceeds the interest rate, lenders are losing money in real terms.
Looking back to historical information and comparable inflationary periods, most of the outperforming risk-averse asset managers and hedge funds avoided investing in fixed income instruments during such periods.
On the flip side, fixed income instruments were the favourite of risk-seeking managers, who invested in high-yield instruments, including distressed debts, to compensate for the underlying risk as well as the nominal inflation rate.
Implications from an accounting perspective
• Debt instruments at amortised cost:
In a rising interest rate environment, it is more likely for debt instruments to be held to maturity rather than being prepaid/refinanced by borrowers.
This might not be consistent with the forecast cash flows’ timing when the instrument was originated – which could lead to changes in the amortised cost value because standards require these to be dealt with prospectively as a change in estimate.
Higher interest rates also affect impairment reviews of debt instruments. There will likely be an increase in the probability of default, as well as the discount rate in determining the exposure at default and the loss given default.
• Debt instruments at fair value:
Generally, the fair value of a debt instrument is determined by discounting future cash flows that are expected to be received from the instrument by the relevant market yield to maturity.
The market interest rate is one of the key factors in determining the market yield to maturity. Generally, increasing the interest rate will increase the market yield to maturity and ultimately decrease the fair value of the debt instrument.
On floating rate debt instruments, future cash flows are updated to reflect the changes in interest rates similar to the change in the market yield to maturity and, as such, the fair value is expected to be at or close to the principal amount.
However, on fixed rate instruments, future cash flows are not expected to change, with an increase in the related discount rate to reflect the market changes that will usually lead to a decrease in the fair value of the instrument.
• This advertising feature was first published in Businesslife's Funds Edition in August 2022
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