Low rates have protected private credit markets from the weight of staggering leverage, but should the US Fed lose control of inflation, future growth opportunities are likely to suffer, according to Dwight Scott, senior managing director and global head of GSO-Blackstone.
“We started with an over-levered market, and now we’re adding more leverage to meet liquidity needs and under-earning,” Scott said during an interview at Investment Magazine’s Absolute Returns Conference on Wednesday.
“So it’s time to think about lowering your yield expectations and not just relying on the existing multiple expansions.”
Scott is quick to point out just how much support extraordinary monetary policy offers US-lending companies affected by the Covid19 market-wide shutdown.
“We did the math and found this drop in interest rates and libor does more than offset the lost revenue over a five year hold period,” he said.
“The company’s free cash flow is about the same, even a little bit better, so if the multiples that they sell the business at improve because of these lower rates, then they’re better off.”
Despite outstanding US treasury credit rising US$4 trillion this year, with the US Federal Reserve’s balance sheet up US$3 trillion this year, the cost of debt in 2020 will be down by 25 per cent, Scott said.
“We are putting on a lot of leverage but these interest rates protect us,” he said.
But ultimately the increase in leverage is a challenge for growth in the future, and Scott warns should the US Fed lose control on inflation and interest rates are forced higher, that will have a significant effect on the budget deficit and will introduce credit market volatility.
“Interest rate declines hide mistakes,” he said, adding declining rates cannot go much further.
“So for the credit markets, you won’t be able to rely on the capital gains that come from rates coming down and multiples going up.
“As such, yield is going to be a very important part of people’s return expectations in the future.”
Scott said the Australian market has always been conservative, and investors should not move up the risk curve just because underlying rates are dropping.
“Volatile periods, whether they be politically driven, economically driven, will always create opportunities for distressed investors, but we’re not at the beginning of a long, positive distress cycle,” he said.
“In fact, we’re at the beginning of a long, basic yield cycle where it might be lower than it was two years ago, but it’s going to be a place you can outperform.”
Cyclically, Scott outlined how private markets went into a holding pattern during the Covid19 slump earlier this year, as public markets traded in leveraged market loans which returned handsomely.
“It was a lot easier to shoot those fish than to originate a new private deal,” said Scott. “And all the capital turned in that direction, and private markets slowed down.”
While that is picking back up now, Scott said the pricing strength from lending will fall out as the world continues to chase yield.