Interest rate rises could have a negative effect on covenant strength as some companies are forced to refinance at higher rates, advisers have said, and trustees should keep a watching brief to mitigate any resultant impact on their sponsors' ability to pay scheme contributions.
In its August inflation report yesterday, the Bank of England confirmed the interest rate would be kept at 0.5 per cent and “was expected to remain below average historical levels for some time to come”, in part due to slower than expected productivity growth.
Richard Butcher, managing director at independent trustee PTL, said many schemes think about interest rates in terms of their liabilities and less so with regards to its effect on their sponsor's financial strength.
“For some employers [a rise] really could be quite critical,” Butcher said. “In the same way you might speculate what might happen to personal debt when interest rates go up – there’s currently a lot people paying very low rates on their mortgages – it’s exactly the same for some companies; they’re paying very low interest rates on their facilities.”
Gary Squires, partner at covenant adviser Zolfo Cooper, said rising interest rates could affect a company in several ways, including refinancing, rising costs and falling revenues from reduced consumer spending, which could affect the affordability of the employer’s contributions and weaken the covenant.
Trustees should factor these issues into their funding and investment decisions, Squires added.
“If the company undergoes a refinancing, trustees need to be aware that they may be subordinated if previously unsecured facilities become secured, weakening the covenant. In response, trustees need to look for opportunities to mitigate any detriment to their schemes,” he said.
Understanding the overall impact on the covenant, which smaller schemes have typically not been doing to date, is critically important
Darren Redmayne, Lincoln International
However, Darren Redmayne, head of pensions advisory at covenant specialist Lincoln International, said that while trustees should be wary of the potential impact of their sponsor’s deteriorating trading levels and higher borrowing costs, “there may be a beneficial reduction in the scheme deficits supported by sponsors, partially offsetting this”.
He added: “The Pensions Regulator is encouraging trustees to scenario plan for such events, which is sensible risk management and a key aspect of the new scheme funding code… Understanding the overall impact on the covenant, which smaller schemes have typically not been doing to date, is critically important.”
Many schemes have an employer financial representative on their boards, but trustees should apply their own in-house stress tests where possible in order to validate the employer view on covenant strength, said Simon Kew, director of pensions at covenant specialist Jackal Advisory.
For schemes that do not have the in-house capability or where there are complexities, trustees could have that particular issue assessed “rather than a full, root and branch covenant review at a high cost”, Kew added.
The BofE’s inflation report gave no indication as to when rates might begin to rise, but said any moves would be incremental.
It stated that the “path for monetary policy, even after the first rise in bank rate, would remain dependent on economic conditions”, adding: “In other words, the committee’s guidance on the likely pace and extent of interest rate rises was an expectation, not a promise.”
