The Cost of Capital Is Up – Your Guardrails Should Be Too

Key takeaways

  • Higher central bank policy rates have increased the cost of capital for corporations and other issuers of debt.
  • Asset classes that are experiencing those higher interest costs sooner, such as leveraged loans and certain real estate markets, may warrant caution.
  • Our strategy for navigating higher interest rates is to take a measured approach. We are proponents of owning more high quality, defensive asset classes.

The cost of capital is up – your guardrails should be too

A direct repercussion of higher central bank policy rates is on the cost of capital for corporations and other issuers of debt. However, not all issuers feel the impact of higher rates at the same time, and we’re more cautious on asset classes that are experiencing higher interest costs sooner.

Why? First, the increased cost of making these higher coupon payments has to come from somewhere, i.e. higher costs on debt repayments can result in fewer dollars available to spend on investing in and growing their businesses. Second, in the more extreme example, issuers whose costs have risen beyond their capacity to pay their coupon requirements could face default, which would impair the price of the bonds to debt holders. Lets bring this to life with a few examples.

Leveraged loan issuers are prone to bear the cost burden

Take leveraged loans, commonly known as bank loans, for instance. One of the most attractive features of bank loans to investors is their floating rate coupon structure, which makes them very low duration bonds. Duration is a measure of interest rate sensitivity. The longer a bond’s duration, the more price sensitive it is to changes in interest rates. Thus, zero duration floating securities like leveraged loans are less vulnerable to rising rate-related price downside. This is exactly the benefit investors in bank loans experienced in 2022 as the Fed raised rates seven times. From the first Fed rate hike on March 17th, 2022 through year-end, the Morningstar LSTA US Leveraged Loan Index returned 0.75% compared to the much longer duration Bloomberg US Aggregate Bond Index, which returned -7.94% (source: Morningstar).