Janet Yellen apparently likes to keep investors on the edge of their seats. Although she told Congress yesterday that she expects the economy to grow in 2014, she didn’t give any timeframe for when interest rates would be increased.
These prolonged, near-zero interest rates are causing many LPs to cautiously eye inflation rates.
One area that has become a growing concern for many LPs is inflation. “Inflation is an exogenous risk,” explained Alex Massa, co-founder of TINCO Global, a senior lender that offers loans linked to the CPI-U index. “When you speak to most investors today, they don’t necessarily view US inflation as a real problem for the next 1-2 years. Yet they still want inflation protection — because they need to address all risks. If inflation does occur, it will be too late for investors to buy affordable protection.”
Investors traditionally mitigate inflation risk by buying inflation-linked securities. Today, treasury inflation-protected securities (“TIPS”) are the most common inflation-linked product — “they are issued by the US government, and are pegged against a CPI benchmark so those who lend to the government get CPI-linked returns,” explained Massa.
However, many LPs are now seeking alternatives to these government-affiliated securities. “In the last few years…TIPS failed in their job,” commented Massa. “They became highly volatile, speculative securities instead of safe, boring, inflation-protected bonds. Demand is now increasing for TIPS alternatives.”
The demand is primarily from LPs seeking portfolio diversification and wealth preservation. Marc Weinstein, co-founder of TINCO, explained, “Products with inflation-linked returns are now part of a growing institutional allocation target.”
Weinstein continued, “For example, in 2008 CALPERS had 0% of their portfolio allocated to inflation-protected securities. By 2013, this allocation grew to 4%. If we take that trend and apply it across the entire market — it becomes clear that inflation-linked allocations are on the rise.” Massa added, “For these groups, even a 1-2% shift in allocation means hundreds of billions of dollars.”
Weinstein also noted that insurance companies are particularly interested in inflation-linked securities. He explained, “Insurance companies have certain liabilities that are pegged to inflation like CPI-U-linked annuity products. They need to match their assets and liabilities and are therefore looking for new inflation-linked investments.”
Lenders that can meet the demand for inflation-linked products will be able to differentiate themselves from competitors. “It is a hyper competitive market for lenders,” explained Weinstein. “Offering CPI-U linked financing with unique terms is a way to stand out. Everyone, from banks to small ABL shops, is trying to carve out a corner of the market.” TINCO partners with lenders to help offer these terms and lower borrowing costs.
TINCO has further differentiated itself from the market by offering “unique terms such as fixed cash interest and a variable CPI-U payment-in-kind (“PIK”) interest. This moves interest rate risk to the balance sheet and away from the cash flow statement.”
However, not all borrowers can benefit from these types of loans. Massa commented, “Service businesses or companies in distressed situations are not good candidates for inflation-linked strategies. We only lend to healthy businesses with hard assets.”