In June South Africans heaved a collective sigh of relief when, after much speculation about a possible downgrade of the country's credit rating to sub-investment grade (damningly known as junk status), South Africa's investment-grade rating was affirmed by the big three credit rating agencies.
A rating of BBB- or higher by Fitch or Standard & Poor's (S&P), or Baa3 or higher by Moody's, is considered to be investment grade. Moody's affirmed South Africa's rating of Baa2 with negative outlook in May. S&P affirmed its rating of BBB- with negative outlook in June and Fitch affirmed its rating of BBB- shortly thereafter, with stable outlook.
While the affirmation of the country's investment grade status was welcomed, it is also viewed with a degree of caution as ongoing concerns around low growth and political factors have yet to be addressed. The next review is due in December. While it may be difficult to predict the course of events until then, it seems likely that South Africans will be holding their breath once more.
What to do with all that junk?
As a result of concerns around South Africa's sovereign rating, foreign lenders may seek to manage their counterparty risk by including rating triggers in newly concluded funding documents with South African borrowers. Some existing funding documents between South African entities and foreign investors will already contain such triggers.
A rating trigger is a type of covenant in bond or loan documentation that obliges the borrower, or the country where it is incorporated, to maintain its rating above a certain level. If the rating is not maintained, specific measures are adopted with the aim of protecting the lender from the borrower's increased risk level. While they are often heavily negotiated, rating triggers generally fall into three categories. The first category, once triggered, obliges the borrower to put up additional security for its obligations. The second category provides that on an adverse rating event, the interest rate payable by the borrower is increased to compensate the lender for the increased risk. Thirdly and more severely, a rating trigger may accelerate the borrower's repayment obligations under the loan.
In exceptional circumstances, a rating trigger may activate a rating-based put provision, requiring the borrower to buy the debt back from the lender. Finally, the most severe rating triggers result in an automatic event of default by the borrower.
The trigger event may include one or more thresholds, or may be combined with other risk events such as a material adverse change. The event needn't be a downgrade per se, and could even refer to the borrower or sovereign being placed on negative watch.
Pros and cons
Sovereign downgrades can result in corporate rating downgrades due to the adverse market conditions associated with the sovereign downgrade. Although the sovereign ceiling rule (ie that a corporate rating can never exceed that of the sovereign) is no longer strictly applied, it is still fairly uncommon for corporate ratings to pierce the sovereign ceiling. Sovereign credit ratings depend on various external factors and macro-economic conditions. A borrower may find that its fate is tied to the maintenance of a sovereign rating over which it has no control.
The use and severity of rating triggers tend to increase in times of economic weakness, as parties seek to protect themselves from the potential deterioration of their counterparty's credit quality. Depending on the type of trigger, lenders are able to price in the increased risk, call up the loan or put the borrower into default if the rating is not maintained. Thus the counterparty risk associated with a particular borrower is purportedly mitigated. As a quid pro quo, some borrowers insist that the rating trigger includes an upside, such as a decrease in the applicable interest rate, in the event that the rating improves during the term of the loan.
Lenders may need to actively monitor a borrower's compliance with various other covenants, but one of the benefits of rating triggers (from a lender's perspective) is that monitoring them is simple and inexpensive. A lender need only check the relevant rating agency's website, or the financial press to monitor compliance with this type of covenant. There is no need to rely on the borrower's internal monitoring, or to incur auditors' costs in performing its own review.
On the other hand, rating triggers may actually increase the risk of a borrower defaulting on its obligations. In one of the first studies on rating triggers conducted by Moody's in 2001, it was noted that the operation of more punitive rating triggers, such as acceleration and termination, may intensify a strained borrower's liquidity problems, thereby increasing default risk by pushing it further into financial distress.
Rating triggers are usually applied to riskier borrowers, which are more vulnerable to the increased payment obligations, and the associated loss of confidence arising from the activation of the trigger. In respect of corporate ratings, further rating action may follow from the loss of liquidity caused by the activation of the initial rating trigger, sending the company into a death spiral. If the chain of events ultimately results in bankruptcy, all the borrower's creditors will be adversely affected and may see their claims go unsatisfied.
The upshot is that borrowers should consider the consequences carefully before agreeing to the inclusion of rating triggers in their funding agreements. The inclusion of a rating trigger may reduce a borrower's cost of funding in the short term, but other relevant factors include whether the particular trigger is consistent with the company's other obligations, how many rating triggers the company is subject to and, crucially, the potential impact if several triggers are activated simultaneously.
As published in Without Prejudice in November 2016.