Higher interest rates: insights for capital markets

Origination volumes are down and investors are wary as interest rates rise, but capital markets can offer opportunity as well as risk. J-P Nowacki, EMEA commercial head of CSC Capital Markets, and David Kim, managing director for CSC Capital Markets, discuss how the sector might adapt to the new environment.

One result of the pandemic is the end of the era of historically low interest rates. Some theories suggest that aggressive monetary policies during lockdowns as well as other factors led to an inflationary environment, which central banks have countered by increasing interest rates.

Geopolitical tensions and a rising cost-of-living have contributed to a sense of uncertainty. Companies and governments have seen debt burdens rise due to higher interest rates.

Against that backdrop, many investors have become risk averse. Investment activity has slowed in many markets as individuals and institutions wait for more certainty.

The question is: what happens next? Has inflation peaked? Will interest rates begin to fall? And in a higher interest rate environment, where are the opportunities in capital markets?

Higher interest rates: a plateau not a peak

What of interest rates? “In the US, the peak may be close,” says David Kim, managing director for CSC Capital Markets in New York. “After the last rate hike of 25 basis points, the Fed softened its language regarding future policy tightening, increasing the likelihood of a pause for the next couple of meetings.

“Inflation is falling, but I think the question is: will it continue to fall at its current pace—which is still too high for the Fed’s liking—or will we reach the Fed’s target rate sooner? The labour market remains strong, with unemployment close to historic lows, so there may be continued inflationary pressures. Any market expectations for rate cuts later in the year seem to have been pushed into 2024.

“Then you take into account the third bank failure in First Republic and the concern about regional banks, particularly related to their exposure to commercial real estate. The debt ceiling negotiations created additional volatility in the equity markets, contributing to an overall sense of uncertainty in the US right now.”

“Uncertainty is much in evidence in the EU and the UK as well,” says J-P Nowacki, EMEA commercial head of Capital Markets for CSC in London. “The energy crisis has impacted Europe much more than the US, so we’re still dealing with the consequences of that.

“In the UK we’re seeing the secondary effects of that initial wave, including some stubborn inflation, particularly in food prices, with the Bank of England recently acknowledging that the UK may be experiencing a wage price spiral.

“The Bank of England’s ‘whatever it takes’ message suggests we may have further to go with UK interest rate increases, but a great deal will depend on the next rounds of employment data.

“Elsewhere in Europe we’re also seeing continued signs of inflation, albeit at slightly lower levels, with the ECB most recently upwardly revising their inflation predictions from levels published earlier in the year. As a result the ECB has indicated that there could be more rate rises than thought earlier this year, with 25bps increases in June and July seeming very likely.”

“It’s a balancing act,” Nowacki adds: “Energy prices have fallen sharply from last year’s highs but we are seeing some knock-on inflationary pressure. Central banks are likely to remain cautious.”

Reduced activity in equities and credit markets

Interest rates on both sides of the Atlantic may be nearing their peak. But it is very likely there will be no return to pre-pandemic levels for the foreseeable future. Higher interest rates, or rather a reversion to the historical mean, will be something markets may have to learn to live with.

This could make stocks less attractive. The tech sector was especially badly hit in 2022, suffering large price declines, though Kim notes that the sector has regained some value this year.

Many corporations are affected by rising interest rates as higher debt burdens act as a drag on profits. Equity investors could rotate to bond markets that now offer more attractive yields.

Credit markets are more difficult to pin down. The performance of securitisation and structured finance instruments very much depends on the underlying assets.

“Various forces are at work,” says Nowacki. “So what happens with things like CLOs (collateralised loan obligations), where you have leveraged loans to sub-investment grade corporates, will be interesting.”

CLO pricing is likely to suffer as defaults rise. Investor caution could feed into reduced volume. “Investors are naturally being more vigilant, and that’s true in all asset classes that are sensitive to interest rates,” says Kim.

“Issuance is also down in mortgage and auto finance markets, simply because new asset origination volumes are lower as a higher proportion of new purchasers are cash buyers.”

In consumer finance, the chances of defaults rise as households feel the squeeze. The same is true of the commercial real estate market, where confidence has been further dented by high office and retail vacancy rates post pandemic.

Safe ports in the interest rate storm: capital market opportunities

Despite these concerns, this is far from a wholly downbeat picture. The old maxim that money can be made in any market is also true here.

“The nominal price of securitisation instruments should fall in a rising environment,” says Nowacki. “From an investor perspective it’s appealing because you’ve often got floating rate exposure. That can be good protection against a rising rate environment.”

Nowacki adds: “capital markets are far more robust than at the time of the 2008 financial crisis. Deals are more conservatively structured. Financial institutions are subject to more rigorous liquidity tests. That creates a higher level of confidence around securitisation vehicles.”

Kim says that, in the US, “origination volumes are starting to increase after being suppressed for the past 12 to 18 months. And then there are these esoteric asset classes that aren’t sensitive to interest rates—like aircraft and equipment finance—that have been moving at pace.”

Discerning investors in consultation with their professional advisors can still find value in traditional assets. Commercial mortgage-backed securities (CMBS) are a case in point. Office-backed deals may be subdued but those based on logistics assets could offer robust returns in a discounted market.

In other words, investors are more vigilant and selective but they are looking for safe ports—and capital markets continue to provide them. The sense is of a sector slowly adjusting to a higher interest rate environment.

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