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Covid-19, Credit downgrades and Caps

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Covid-19, Credit downgrades and Caps 4

Data from the Bank of International Settlements show that, since 2008, corporate debt has risen by more than 50% to over $72 trillion as low interest rates enticed companies to take on record amounts of cheap debt. The sudden and unexpected global shutdown brought on by COVID-19 will now make it difficult, if not impossible, for many companies to service or refinance these loans and a slew of credit downgrades from the rating agencies can be expected in the coming weeks.

Sectors like retail and travel have already been in the firing line with S&P downgrading airlines Lufthansa and IAG (owners of BA) last week to BBB-, the last notch before losing their investment grade rating. The creditworthiness of sovereign nations has also been reassessed with Fitch downgrading South Africa to junk and the UK to AA-, and put on negative watch for additional cuts to its rating.

Tighter regulations and supervision have left banks better able to withstand economic shocks and they are in better shape now than when we entered the last major economic crisis in 2008. However, a decrease in the quality of their assets (loans), operating environment and narrowing net interest margins due to cuts in official interest rates mean that banks are also vulnerable.

For companies whose hedging bank and lender for derivatives are the same entity, the specific rating of their bank may not be an issue. However, the increased prominence of non-bank lenders, especially in the Real Estate space, means that this may not always be the case. Where this can potentially become problematic is when a derivative like an Interest Rate Cap is a condition of loan sanction and the lender stipulates that the hedging bank maintains a minimum credit rating not only when the Cap is transacted, but also during the life of the Cap. Depending on how the contract with the hedging bank is drafted, the cost of replacing the Cap may be borne by the borrower. This may be an expensive and a difficult exercise at a time, like now, when financial markets are dislocated, and the universe of acceptable counterparties could shrink

For existing transactions, a review of the Facility Agreement and the ISDA or Long Form Confirmation is the starting point to determine if the creditworthiness of your hedge counterparty poses a material risk. For upcoming trades, it’s vital to assess both the credit quality of your counterparty and how a downgrade cure will be documented in both the Facility Agreement and the Hedge documentation.

As experienced financial risk professionals, the team at Vuca Treasury is well positioned to help you navigate safe passage through these volatile times. Contact us at info@vucatreasury.com if you would like an independent perspective on how to mitigate your financial risks during these extraordinary times.

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