Credit cycle turning as Ukraine war adds to inflation concerns

Earlier this month a food provider to US prisons offered up a deal containing all the hallmarks of a frothy debt market. TKC Holdings had struggled to raise debt last year, penalized by more socially responsible investors reluctant to finance the prison industry.

Unphased, TKC went back to investors this year looking to raise $ 305mn, to fund a payout to its private equity owner HIG Capital, according to rating agency reports and people familiar with the deal.

The deal was pitched with a whopping coupon of 12 per cent, rising as high as 13.5 per cent if the company opted to defer interest payments – a feature known as payment in kind or “PIK” and a warning flag to credit investors wary of a company’s ability to pay its debts. So, did they struggle to get the deal done? No. It was increased to $ 320mn, suggesting strong investor demand.

While investors have fretted over inflation, weighing on the value of stocks and corporate bonds, leveraged loans have proved more resilient.

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

The diverging fortunes of the two markets points to their differing sensitivity to inflation pressures and changing 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 fresh bonds offering a higher rate of return hit the market. As the US Federal Reserve readies to raise interest rates in March, investors have withdrawn billions of dollars from funds that buy US high-yield bonds so far this year and poured money into funds that buy US leveraged loans.

For now, it says more about the different sums used to price bonds and loans than the likelihood corporate America can afford its debts.

The TKC deal showed that investors remain sanguine about lending to risky companies – especially when there is a hefty amount of interest to be earned – even if they are worried about the impact of tighter monetary policy.

While investors have increased their expectations of where interest rates will be going forward, raising corporate borrowing costs, they have not dramatically altered their pricing of the risk of lending to companies, expressed as the difference between corporate bond yields and “risk-free” US Treasuries.

Economic growth is in tact. Default rates are expected to remain low. Corporate earnings remain solid. Up to now, the sell-off in credit markets has been more about the expected path of interest rates than rising credit risk.

This week, that started to shift. As rockets launched and tanks rolled across the border into Ukraine, oil prices soared past $ 100 for the first time since 2014. Russia is a big exporter of oil and the crisis could constrain that supply, pushing prices higher.

Oil prices are an important input into inflation metrics. Benchmark 10-year break-even inflation rates, a market measure of inflation expectations, jumped almost 0.2 percentage points for the week to Thursday. Rising oil prices also have knock-on effects, increasing costs for companies and pushing them to raise prices of their own. There could also be renewed supply chain disruption from the crisis, further impacting inflation measures.

The Fed has already been trying to walk the tightrope between being hawkish enough to signal it is serious about tackling inflation, while not so hawkish that they risk raising fears over slowing economic growth. The unfolding crisis in Europe amplifies the risk of the latter, and slowing growth could propel a sell-off from being mostly contained to interest rates to threatening 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, have also crept higher, indicating slow-rising credit risk.

Part of this is a more technical reaction in financial markets. As investors have yanked money out of high-yield bond funds, those funds have had to sell corporate bonds, pushing yields higher. While different, corporate bonds and loans are still both based on the risk of lending to a company, keeping their prices somewhat tethered to each other.

Some investors also said that they had seen loans being sold in favor of cheaper – but broadly similar – bonds, pushing loan prices lower. But others on Wall Street argue the price moves aren’t just a technical reaction. As Russia’s offensive escalated this week, sentiment in credit markets began to shift.

There is growing unease among some investors over the conflict, what it means for the US economic outlook and in time, whether it’s enough to turn concern over rising prices into worries over corporate credit.

joe.rennison@ft.com

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