Rapidly rising interest rates will impact the cost of corporate borrowing and this in turn could affect both the ability of companies to make contributions into their pension scheme and even the sponsor’s ultimate viability, LCP has warned.

According to LCP partner Helen Abbott, the consequences of rising interest rates will vary considerably from firm to firm and trustees need to “get under the skin” of what rising borrowing costs may mean for their sponsor.

Key issues for companies include:

  • The rising cost of borrowing will come on top of other cost pressures such as rising energy bills and supply chain issues; if debt has to be ‘refinanced’ at a much higher rate and/or with greater restrictions, this could be the last straw for some firms;
  • Current market conditions come off the back of a series of interventions by the UK government to support firms through the COVID pandemic; in some cases, businesses will already be carrying additional debt incurred during the pandemic, and they may already be at the limit of the debt that they can service;
  • The reaction of banks will be key. Where firms are struggling to meet repayments – or will struggle to meet increased debt servicing costs – banks will need to decide whether to ‘pull the plug’ or exercise forbearance in the hope that the situation will improve. The attitude of the banks and their expectations of the future state of the economy could be critical for many firms;
  • Some firms will be cushioned from the immediate impact of rate rises where their debt is largely in the form of bonds which will usually be at fixed rates. Maturity dates on bonds are usually spread to avoid refinancing cliff edges, but at each refinancing the situation could get tighter.
  • Where firms rely more heavily on bank lending this is more likely to be on a floating rate, in particular working capital facilities which might now be needed more heavily, so any increase in rates would feed through to the bottom line relatively quickly. Where firms have had fixed term bank lending to tide them over the pandemic, many may be coming for renewal around now, and banks may be reluctant to offer decent fixed rate terms at the moment given the uncertainty about the interest rate outlook.

LCP pointed out that the tightness in financial markets has led to a big reduction in M&A activity in the last six months and this could lead to negative outcomes for firms that might not survive without some form of restructuring.

“Rising borrowing costs are bad news for corporate Britain, but the impact on individual firms will vary considerably. For some sponsors of company pension schemes, these increased costs come off the back of other costs pressures as well as debts arising from the pandemic,” Abbott said.

“Increased debt servicing costs could be the final straw,”she added.

For other firms, the impact may be less immediate, especially if some of their financing is via corporate bonds which will only need refinancing on a gradual basis, she said, adding that for many businesses it will be the attitude of the banks that are key.

“Trustees need to stay close to their sponsors during these turbulent times and make sure they have a thorough understanding of how the rising cost of servicing debt will impact the strength of the employer covenant”.

Implications for pension schemes

Meanwhile, the large increase in government borrowing required to finance the measures announced last Friday has caused major gyrations in financial markets. Gilt yields have moved significantly higher and sterling lower against both the US dollar the euro.

”UK credit spreads have widened. In summary the market now perceives the UK to be a more risky place to invest and demands greater risk premia to do so,” said Pavan Bhardwaj, trustee director at Ross Trustees.

“The steps announced by the Chancellor are inflationary and create an inherent tension with the Bank of England, which has been increasing rates to try and bring inflation under control,” he added.

These moves have accelerated a shift higher in bond yields which was already occurring, due to the tightening of global central banks in order to combat inflation, Bhardwaj continued.

“Schemes have already been required to recapitalise LDI portfolios, which entails selling out of growth assets into LDI, due to the higher yields. Liquidity is therefore the key concern going forward – schemes with high allocations to illiquids could potentially be required to take a haircut on these assets or, in extremis, reduce the target level of hedging.

In order to restore market functioning and reduce any risks from contagion to credit conditions for UK households and businesses, the BoE announced today that it would carry out temporary purchases of long-dated UK government bonds.

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