Low inflation was in part responsible for fostering a transfer of returns from creditors to shareholders

Duncan Sankey

Portfolio director and head of credit research Cheyne Capital

We are conditioned to fear inflation risk. But it brings plenty of positives

It only took price levels to peep — like the first snowdrop after winter — above the central banks’ 2% target rate for the commentariat to mourn the passing of ‘sound’ economics.

It remains to be seen whether inflation expectations become ‘unanchored’ (the latest University of Michigan consumer sentiment data suggest not), but we can venture some thoughts on the impact of inflationary pressures on investment grade credit. And you know what? It’s not all bad.

First, there is no clear correlation (let alone causality) between inflation expectations and credit spreads. If anything, since the turn of the millennium, higher US inflation (as measured by the PCE core deflator) has generally been accompanied by tighter US triple B bond spreads.

Intuitively, this makes sense. A buoyant economy generates some transactional friction, but the strength of demand should allow corporates to boost prices and margins, all other things being equal. Stronger margins equate with higher debt service coverage and, by extension, lower default risk, which is reflected in tighter spreads.

There is little danger of wage inflation

Inflation hawks, stuck in a loop of ‘That 70s Show’, may assert that a wage spiral precipitated by spiking commodity prices threatens a re-run of post-oil crisis inflation, with disastrous results for corporate earnings, especially given a labour force that to some eyes has grown bolshie as post-pandemic job creation temporarily outstrips the supply of workers.

However, this dynamic is likely to prove short-lived, since labour retains a feeble bargaining position. Whereas a quarter of US private sector workers were unionised in the early 1970s, that figure is now around 6%. Recent victories for some workers in the gig economy belie the generally unaccommodating regulatory environment, at least in the Anglosphere.

Culturally, unions are as relevant to the economic zeitgeist as lava lamps: could you imagine a band today having a top 10 hit with “(You won’t get me I’m) part of the Union”? (A number two in the UK for The Strawbs in January 1973). Moreover, rising wage costs and raw materials prices have not dented IG corporate margins, which remain close to multi-year highs.

The decade of sub-target inflation ushered in by post-global financial crisis monetary policy also had a deleterious effect on the risk appetites of IG corporate managements. In the absence of robust price signals encouraging them to invest in new capital, US business investment as a percentage of GDP over the past decade has languished below its 22.4% average since March 1947 and well below the record 25.4% in December 1978.

US managements instead turned to financialisation as a means of boosting shareholder returns, handing back to shareholders $5.3 trillion in stock repurchases (and $3.8 trillion in dividends) over the decade. Much of this was funded, directly or indirectly, by record low-cost debt, taking US IG median leverage to decade highs before the onset of the pandemic. Low inflation was in part responsible for fostering a transfer of returns from creditors to shareholders.

Inflation can induce organic deleveraging

High IG leverage is admittedly not a pressing problem. IG companies used bondholders’ desire to wring a few extra basis points out of duration extension to push out debt maturity runways at low cost, with the result that few face material near-term refinancing risk, while current coverage ratios remain robust. (And, contrary to expectations, bond yields have tumbled since May).

However, the wealth transfer implicit in inflation (from creditors to debtors) will also go some way towards helping IG companies deal with debt piles. Inflation increases the nominal value of earnings and assets, while that of debt and fixed debt service costs remains constant, leading to an organic deleveraging as price levels rise.

This assumes managements don’t embark on another round of liberality towards shareholders. Early signs are encouraging: capex has seen a resurgence, in part as companies embrace new technology to deal with the pandemic. Conversely, buybacks and dividends remain well below their 2019 peak as managements remain chastened. Rather like that Strawbs anthem, ‘shareholder value maximisation’ feels a bit passé.

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Global credit funds & CLO's

August 2021 | Issue 237

Published in London & New York.