This post addresses our insights into inflation risk and how it effects Cortland’s flagship private debt strategy.
First off, we would like to note that inflation is a major issue for central bankers all over the world. The first core function listed by the Bank of Canada on its website is to keep inflation low, stable, and predictable. With the latest consumer price index (CPI) reported at 7.7%, while having a target of 2%, our central bank is far from achieving any of these components. In the U.S., inflation is even worse, with the latest year-over-year inflation report coming in at 8.6%.
Portfolio managers in the capital markets appear to have a lot of confidence that the central banks will be effective in bringing inflation back towards long term targets. In our expectation, it will take a lot to slow inflation. We are seeing rapid escalation of prices in several core items. Food prices are an important example. The war in Eastern Europe pits the world’s largest exporter of wheat, Russia, against the fourth largest, Ukraine (also known as Europe’s breadbasket). It is hard to forecast the cost of bread, not to mention pasta and meat which look to grain as a primary input, declining.
A second important key contributor to inflation is energy costs. Costs in this industry have risen dramatically, recently – for example, the average cost in Ontario rose 43% in the last year. With European countries searching desperately for non-Russian energy sources, we see no downward pressure on this key consumer expense.
Another major item is housing. The average price of a home in Canada (Canadian Real Estate Association’s home price index) grew by 19% in the year up to April 2022. Unfortunately, rates charged by mortgage lenders have risen as well, such that the annual interest paid for a young family starting out, with 20% down-payment, is up 28%.
In response to the massive increase seen in inflation this year, monetary policy rates are being raised by central banks to tighten the economy. The amount of interest rate hikes expected from central bank meetings in Canada is priced into money market futures contracts. In Canada, we use Bankers’ Acceptances futures – these contracts are predicting interest rates will be 2% higher by year end. In the US, the central bank (the Federal Reserve) is about 25 basis points ahead in tightening, and the market is expecting they will raise rates 2% from the current level by the end of 2022 as well.
How does it affect Cortland flagship strategy?
Cortland’s flagship fund (Cortland Credit Strategies LP) is focused on issuing private loans to lower middle market companies that are unable to get traditional financing. Over 90% of the firm’s private debt assets tie lending rates to changes in other money market rates, such as the prime lending rate at a major bank. One of the features of our strategy is that returns are expected to grow with rising monetary policy rates. As lending interest rates continue to move higher, rates charged on our floating rate loans will also move higher and our investors can expect to benefit.
As a short-term lender, the nature of our loans allows us to frequently review and re-assess investment decisions. This effectively means, when one of the underlying portfolio companies is underperforming due to a slowdown in the economy, we have a quicker exit opportunity compared to traditional direct lenders. Additionally, our private debt assets are mainly comprised of senior-secured asset-based loans, which provides strong principal protection in the case where borrowers are unable to make payments.
After almost 10 years of operating in a direct lending landscape, we are confident that our strategy is able to deliver consistent risk-adjusted returns throughout various market conditions. This belief is supported by robust investment due diligence, strong collateral support, and frequent risk monitoring of our loan book.