Using Private Credit to Hedge Against Rising Interest Rates
As the Federal Reserve continues its process of quantitative tightening, many investors are concerned about rising interest rates and inflation. Opportunities in private credit can help investors hedge against these risks.
First, let’s discuss the process of quantitative tightening and what these changes mean for investors.
What is Quantitative Tightening?
In June of 2022, the Federal Reserve (the Fed) began quantitative tightening. Quantitative tightening is the process of withdrawing its support from the U.S. economy and shrinking its record balancing sheet (i.e. its assets and liabilities).
This process may cause interest rates to increase and inflation to decline.
Why is Quantitative Tightening Occurring?
The Fed has started the process of quantitative tightening to counteract the effects of the quantitative easing plan that started in 2020. Following the economic shutdown resulting from the COVID-19 pandemic, the Federal Reserve introduced a quantitative easing plan of over $700 billion and later extended its program until further notice.
These expansions included committing to purchasing at least:
- $40 billion in mortgage-backed securities, and
- $80 billion a month in Treasuries
Why Are Investors Concerned About Quantitative Tightening?
The Federal Reserve has only tried quantitative tightening once. This attempt, taking place in 2018, did not bode well for markets. Business Insider reflects on this process, “stocks fell sharply in 2018… the S&P 500 dropping more than 6%. After about 10 months, the central bank reversed the policy…
The Fed has never attempted QT on this scale before. From May 2022 to May 2023, the four biggest central banks – the US, eurozone, UK, and Japan – are expected to reduce their balance sheets by $2 trillion, which is four times more than 2018.
Investors are concerned about the effects of this process when the Fed has a weak record and lack of experience with QT of this scale.
How Will the Process of Quantitative Tightening Work?
The Federal Reserve will allow its purchased bonds to reach maturity and run off its balance sheet.
According to the Washington Post, the U.S Department of the Treasury “then ‘pays’ the Fed at the maturity of the bond by subtracting the sum from the cash balance it keeps on deposit with the Fed.”
This process will make the money the Fed put into the market “disappear.”
What Should Investors Do Next?
The Federal Reserve doesn’t have a strong history of successfully slashing its balance sheet or smoothly implementing the process of QT. This may leave investors feeling uneasy and unsure of what to do next. At Centura Wealth Advisory, we’re looking to private credit as a solution to the rising interest rates.
Why Private Credit is a Solution in Rising Interest Rate Environments
Private credit can provide several advantages and opportunities in a market with raised interest rates.
Floating Rate Loans
In a rising rate environment, floating rate loans are a highly attractive opportunity for investors. Why? Income increases alongside rising interest rates.
Private credit is typically floating rate. This may help to limit both the rate risk and the duration risk that are associated with traditional fixed income.
Privately Negotiated Deals
Private credit transactions are direct negotiations between the lender and the borrower. This allows investors to access a wide range of private transactions and negotiate terms that best work for them.
For example, private credit investors tend to negotiate for better protections to make credits more defensive, such as a senior secured structure, call protection, or covenant terms.
As the Economy Recovers, Credit Quality Improves
Credit quality typically improves with economic recoveries. While investors should seek the assistance of professional private credit managers to prioritize downside protection, extensive due diligence, and quality of credit.
Let’s Talk Collateralized Loan Obligations (CLOs)
A collateralized loan obligation (CLO) is “single security backed by a pool of debt….Collateralized loan obligations (CLO) are often backed by corporate loans with low credit ratings or loans taken out by private equity firms to conduct leveraged buyouts.”
How Do CLOs Work For Investors?
With collateralized loan obligations, an investor receives scheduled debt payments from the underlying loans. The investor is offered greater diversity and the potential for higher-than-average returns in exchange for taking on the default risk.
What are the Potential Risks of Private Credit?
As with any investment, private credit comes with a few risks. Investors should do proper underwriting to reduce these risks and consider working with professional advisors specializing in private credit.
Default Risk
Default risk is “the risk that a lender takes on in the chance that a borrower will be unable to make the required payments on their debt obligation.” This risk is paramount when investors are investing with private credit.
Interest Rate Risk
Interest rate risk refers to the risk that changes in interest rates may change the market value of an entity investors hold. In this case, investors hold products with a floating rate nature, and rates can adjust as they rise.
Volatility
Volatility can be affected by numerous factors. With private credit and middle-market lending, there is often not much volatility. However, if a factor changes, volatility can increase rapidly. Investors should understand this risk and its context before participating in private credit lending and highly consider working with a professional to mitigate risk.
Tune into Our Podcast to Learn More
In this episode of our Live Life Liberated Podcast, Chris Osmond speaks with Christopher Long, Chairman, CEO, and Founder of Palmer Square Capital Management LLC. They talk about current opportunities in private credit and how it helps investors hedge against rising interest rates (and potentially inflation).
Christopher discusses:
- How the lines between public and private credit have started to blur
- What are CLOs, how they work, and the value they add to your portfolio
- Potential risks in private credit
- The current and future outlook of private credit
- And more
Interested in Learning More About How to Invest in Rising Interest Rate Environments?
At Centura, we are dedicated to our role as stewards in leading our clients to purposeful financial planning and investing strategies to ensure their success. One of our goals is to help our clients navigate and understand challenging economic changes, such as the current rising interest rate environment.
Read our article for more information here.