Why does deflation tend to undermine debt-financed investment?
if value of debt-financed assets declines, the value of equity (which is levered) will decline at a higher/leveraged rate
grows.
if you are earnings an 8% nominal rate and real rates go to a negative -3%, your spread is +11% positive. fixed income instruments actually should grow in value during deflation.
the issue is that falling asset values, price instability, and shrinking profit margins basically undermine the value of companies and consumer’s willingness to spend. that destroys equity and the burden of debt ontop of it (in a world where assets are shrinking by 3%, you are paying 8% on a mortgage, corp. bonds etc.), you (or any company)are getting killed and headed towards bankruptcy.
the credit risk/bankruptcy issue is what drives fixed income values down, but on paper they should be worth more.
CFAI text states:
if value of debt-financed asset declines, the value of equity in the asset declines at a leveraged rate
that is straight from the text - not sure what you are talking about
sorry, thought you were talking about the debt also. my bad.
Its very simple. If you buy a house, and house prices deflate, your asset value plummets but your debt does not. Debt deflation is why our economy is where it is currently.
Just curious, how does the deflation affect the value of a leveraged floater?
No idea, but if I had to guess, I’d say it would have a very slight positive effect on the value if any. Seeing as how interest rates adjust to deflation, and the payment rate on the floater gets re-adjusted to match interest rates every new period, the only benefit you’d get from deflation is the slight increase in real value of your next upcoming payments. All future payments after that would be re-adjusted for deflation.