Lately, we've been hearing constantly in the media about a possible recession and inflation that the world’s major powers are struggling to control. But the question is how this affects us and how we can protect ourselves against these scenarios when it comes to investing.

One of the most traditional ways to combat inflation has always been to raise interest rates, which directly leads to an increase in the cost of living and a decline in the prices of stocks, bonds, and all kinds of assets.

Despite the well-known consequences, the United States has shown us a type of investment that has remained unaffected during periods of rising interest rates and has proven to be extremely resilient in turbulent times: private debt—and in particular, debt that incorporates the so-called floating rate (floating rate).

Before delving into private debt itself, it is critical to clarify that private debt is part of a market distinct from the already well-known High Yield Bonds and Syndicated Loan Banks, as its structure is geared toward financing mid-market companies in the U.S. The main advantage of private debt investments is that, as debt, they have a higher priority for repayment than equity (lower risk and lower return). In turn, within the different types of debt, we can find various categories and priority levels for repayment, which typically consist of senior, mezzanine, and subordinated debt.

The main characteristics of private debt are that it is a widely used investment instrument in SME markets (Small and Medium Enterprises) and, second, that they are issued at floating rate. Consequently, private debt is structured for SMEs based on their cash flows and secured by senior debt within their capital structure.

What does this mean? It means that the cash coupons on this private debt are reset more frequently as rates rise (every 30 or 90 days) and, in turn, have shorter maturities than corporate bonds (corporate bonds have maturities of 5–7 years, while bonds in the SME have maturities of 2–4 years).

Because they have shorter maturities and floating rates that are updated every 30 days, the result is that private debt performs more stably than high-yield bonds and syndicated bank loans, as returns increase in response to rising interest rates through these floating rates. Another factor affecting performance is the fact that senior debt has covenants that provide greater structural protection than corporate bonds.

If you want to continue investing in a safer way while still achieving good returns, private debt may be the best option given the current environment, due to its floating-rate structure and its focus on SMEs.

Diego Covarrubias

AGF Team

 1 Private Credit: Outperforming the Market Amid Rising Interest Rates. Acres Capital Management