Structuring private-credit investments in an inflationary environment

Until the covid pandemic unleashed an enormous wave of government spending, investors had become so used to living in a low-inflation environment they could be forgiven for not having given too much thought to what the impact of rising inflation might be. That attitude could now start to look a little outdated given the potential impact of extremely loose monetary and fiscal policy.

So what if inflation does begin to pick up, you may say? Central banks will respond by raising policy rates to nip any inflation in the bud. Compared to bonds and other fixed-rate instruments, loans are less sensitive to increases in interest rates because interest is typically paid on a floating basis i.e. as a margin over the base rate (say, 3-month LIBOR with a floor of 1%). So loan investors should be ok.

But what if central banks don't respond this way? What if they decide to let inflation run hot either because they want to help governments inflate away some of their enormous debts or because they are terrified of the market's reaction if rates are hiked? Some would view this approach as outlandish - surely central banks will stick to their mandates of maintaining price stability? But before you dismiss the idea, you should consider that it is arguably the case already. Inflation is well above target in both the USA and UK while policy rates are still substantially lower than inflation i.e. negative in real terms.

How much longer would this state of affairs need to continue before the mantra that this bout of inflation is just a temporary phenomenon loses credibility? Central bankers all profess to be highly confident that inflation will quickly subside of its own accord but one might be forgiven for thinking “they would say that, wouldn't they”. Perhaps they are in the dark like the rest of us and just hoping for the best.

In any case there are signs that investors are beginning to get nervous. UK inflation expectations (as measured by the break-even rate on 10-year gilts) have ticked up over the last few months towards 4% compared to the target rate for inflation of 2%.

So what can a debt investor do to mitigate this inflation risk? Floating rate loans on their own won't provide much protection if inflation takes hold as the value of the loan principal will be inflated away. In real terms the investor will receive a much diminished return. This is one of the reasons why at Prefequity we always structure our debt investments with an equity kicker - usually in the form of a free equity warrant i.e. the right to buy some of the company’s equity at a fixed price (the “strike price”) in the future. Other things being equal, any inflation will boost the value of the company’s equity in proportion to its earnings while the strike price of the warrants will be eroded in real terms. So the value of the warrants will be boosted by inflation and act as a kind of self-stabilizer to our overall return as measured in real terms - which is after all what our investors should really care about.