At the end of last week, pension fund investors had to digest the news of further quantitative easing from the Bank of England (and work out what effect that might have on their liabilities because of the likely pressure on gilt yields). At the same time, the widely expected downgrading of a number of UK banks occurred, following in the wake of the same credit reassessment of a number of US and European institutions.
The principal impact of the latter development on UK pension funds is in relation to derivative contracts which funds have entered into with bank counterparties as part of an investment derisking or Liability-Driven Investment strategy. Although investment advisers and LDI managers will be primarily responsible for recommending a strategy, there are important legal issues to consider arising from such downgrades.
A credit downgrade of a bank counterparty is not an automatic Termination Event under a derivative contract written under the market standard template used by members of the International Swaps and Derivatives Association (ISDA). However, well advised trustees will have protected themselves by agreeing with their counterparties that a provision that addresses circumstances where a counterparty’s credit rating falls below a minimum required level is necessary, and so ISDA agreements should contain such a ratings downgrade as an Additional Termination Event. This will give the trustees (but not the counterparty bank) the right but not the obligation to close out all existing derivative positions and stop any new trades from being entered into with the downgraded bank. This right to terminate should not be exercised automatically – the trustees need to understand the financial consequences and consider the rest of the pension fund’s derivative positions with other banks before doing anything.
In assessing the materiality of a credit downgrade, trustees need to ask some basic questions:
- What is the nature of the credit downgrade? Will the credit ratings downgrade be sufficient to mean that the counterparty has triggered a Termination Event? The commercial consequences for trustees will depend on how big the downgrade is: going down one notch will not necessarily mean that a counterparty bank is going into insolvency or may not be able to continue to make its required payments or deliveries under the ISDA agreement.
- What does the relevant ISDA agreement say? There may be additional rights under the ISDA agreement that the trustees could exercise instead of terminating all trades.
- Is the amount of exposure material (both in notional terms and in the current value of the swaps or other instruments)?
- Is the pension fund in the money (ie in profit on the contract(s)) or does it owe money to the bank?
- How much of the trustees’ overall hedging arrangement is with the downgraded bank. Is it material?
Although it might be tempting for trustees who are in the money to reach a swift conclusion to terminate and crystallise a profit, the purpose of any hedging strategy is protection. This might be long term (inflation or interest rate protection) or shorter term protection such as an equity overlay option strategy. Exiting from exposure to one bank means that a replacement bank has to be found. Given the current market conditions, replacement banks are potentially just as likely to be downgraded so closing out a position with one bank might merely concentrate the overall risk (because the trustees would have fewer counterparties to deal with).
Waiving rights to terminate
Any bank which suffers a downgrade below the required threshold credit rating will be under an obligation to disclose such a Termination Event to its counterparties. We have already seen one downgraded bank using this obligation as an opportunity to ask investment managers and trustees to confirm that by continuing to trade with the bank the trustees will waive their rights to terminate the ISDA as a whole. Since until such time as a bank’s rating has been restored to the required minimum level, the Additional Termination Event will be continuing, no precipitate action needs to be taken and such tactics should not be accepted at face value.