What goes up... sometimes gets stuck

Mid-market borrowers are getting closer to the real impact of the battle with inflation.

Much like waiting for a bus in the 90s, interest rate rises have come all at once over the last 18 months, with the UK Base Rate hitting the 5% mark following the last MPC meeting in June. Although many believe we’re close to the upper limit, in recent weeks the Bank of England has been clear in its stance on managing market expectations around a near term rate reversion, and it appears that the possibility of further rate hikes remains firmly on the table.

So if I’m an existing borrower of debt capital, what does this mean for me?

Existing borrowers will already be feeling the monthly cashflow impact of recent rate rises unless they have interest rate protection through hedging (albeit most mid-market borrowers do not). However, most senior loan borrowers’ credit ratios are based on LTM (last twelve month) measures and therefore the delayed impact on covenants, headroom and debt serviceability are yet to be felt. Practically, an LTM covenant measure taken at the end of July 2023, includes interest expenses from August 2022 to July 2023 – including from back when rates were only 1.25%.

Whilst the SONIA forward curve projects Base Rate to peak at around 6.20%, the delayed impact of higher rates on LTM metrics means that debt serviceability is expected not to reach peak tightness until Q3 2024 (yes, you read it right, that is the Autumn of 2024, 15 months away), where a typical unhedged SONIA + 4% leveraged bank loan would deliver a full year’s interest burden in excess of 10%.

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This situation is not too dissimilar to consumers currently treading water with a fixed rate mortgage product. While many corporate and leveraged borrowers have been able keep the initial impact to date managed – regardless of where rates may be heading – in terms of covenant headroom most of the pain is yet to be felt. Borrowers will need to forward plan ways to protect their covenant compliance… or start gearing up for conversations with their lenders around covenant waivers and/or resets. ?

I’m planning to borrow or refinance in the near term, what does this mean for me?

With the UK economy experiencing sticky inflation and Base Rate at its highest in over 15 years, will lenders be forced to re-write the textbooks?

In the mid-market leveraged finance world, whilst there has been some talk of a slight easing in direct lending margins, this is entirely dwarfed by the impact of base rate rises on the overall interest cost. Coupled with growing leverage levels over the last decade, a rise in interest costs may result in prospective borrowers facing tightness in debt service coverage, whether explicitly documented in facility agreements or implicit impacting lenders’ internal parameters.

Particularly for debt funds operating at the higher cost/leverage end of the market, this may cap the total amount of leverage they are able to lend, regardless of borrowers’ willingness to pay higher interest costs, in order to maintain appropriate serviceability levels.

However, corporate borrowers aren’t off the hook. Previously, borrowers looking to bank debt as a source of low-cost funding enjoyed the near-zero base rate environment, essentially paying only the lending margin in interest expense. Here, the impact of recent rate rises will be felt relatively harder as the variable portion of interest cost accounts for a more significant element of the total interest expense... and the current upward trend in rates doesn’t appear to be slowing any time soon.

Here we are likely to see covenant headroom on new loans reduce to more historic levels (albeit the definition of “new normal” is yet to shake out), with both CFOs and lenders having to keep a closer eye on interest cover ratios for the first time since 2008.

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So how do I plan for this? Cross my fingers?

The EY Debt Advisory team has helped numerous clients navigate the current market environment, both from a financing and an interest rate hedging perspective. If you’re concerned about how higher rates could impact your business and how to improve your resilience in the future, we’d be happy to discuss the facets of all of this with you.

Christopher Lowe - Partner, Financing : [email protected]

Zoe Clarke - Partner, Financing : [email protected]

Stewart MacKinlay - Partner, Hedging : [email protected]

Jane Hartley - Director, Financing : [email protected]

Vijay Gupta - Associate Director, Financing : [email protected]

Sophie Humphreys, CFA - Executive, Hedging : [email protected]

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