The Takeaway: Rate Rise Continues; Recession Risk Hits Leveraged Borrowers

August 11, 2022

The Takeaway is a new CoBank publication that provides practical commentary on interest rates and capital markets activities. These insights come from the professionals in CoBank’s Treasury, Capital Markets and Derivatives groups—people who are in the market interacting with customers, investors and other lenders seeking to understand what is driving activity.

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Markets Rally in Response to Latest Fed Rate Hike; Is It Too Soon?

The Fed raised the federal funds rate by 75 basis points to a target range of 2.25% to 2.5% at its late-July meeting in its continuing effort to tame runaway inflation. The move follows the Fed’s 75-basis-point increase in June, meeting what were strongly signaled expectations for both months.

Equity markets rallied in response to the news and Fed Chairman Jerome Powell’s hint that future rate hikes, although fairly certain, could be smaller. Some investors took this to mean that the Fed could begin lowering rates in 2023.

Kiran Kini, CoBank senior vice president and treasurer, isn’t so sure.

“Back-to-back increases of 75 basis points—or 1.5% over two months—amount to a very significant rate hike,” said Kini. “The rally in response to the hike indicates that the markets are resetting expectations for where the fed funds rate is going to end up and starting to price in rate cuts as early as next year.

“But I think it's a little premature to expect the fed to start to change direction and cut rates, or the market to price in cuts, in 2023,” he continued. “It is likely that the Fed will eventually slow down their rate hikes, but inflation is still very high and has come down just slightly. There are some signs that inflation is easing, but it’s going to take time to get down to the Fed’s 2% target.”

Indeed, the most recent statistics indicate that inflation is at a 40-year high. The Personal Consumption Expenditures Price Index for June, which was released on July 29th and is watched closely by the Fed, jumped 6.8% over 2021, its largest increase since 1982. July’s Consumer Price Index was 8.5%, down from 9.1% in June, also a 40-year high. 

Kini indicated the Fed’s rate increases may be achieving their desired effect of slowing economic growth, which would begin to reduce inflation. 

“We also have back-to-back quarters of negative GDP growth, which is fueling debate about the potential for a recession—is it a recession or is it not?” Kini said. “I don't want to get into that debate. At the end of the day, real growth is slowing down and the reason for that is inflation.

“Consumers are still generally in good shape. There is a decent amount of consumer spending, but we're paying more for everything. Inflation is eating into our purchasing power,” Kini continued.

Kini also noted that unemployment remains very low. To the surprise of many economists, 528,000 non-farm jobs were added in July, reducing the unemployment rate to 3.5%, its lowest level in 50 years. Still, several tech companies have announced layoffs recently, and the labor market could begin to turn. And wages continue to grow, although not at the same pace as inflation.

“Time will tell if we are in a recession,” Kini concluded. “If so, it is not at all your typical recession.”

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Volatility Continues to Drive Hedging Interest

Despite the widely held expectations for two consecutive 75-basis-point federal funds rate increases, considerable market volatility continues, as does customer interest in taking advantage of quick interest rate movements, according to Eric Nickerson, CoBank’s sector vice president of customer derivatives.

“Aside from the rate increases, some commentary and responses to questions by Fed Chairman Powell immediately following the last rate decision, were viewed as the Fed being less hawkish than they were before, which is adding to the volatility.” said Nickerson. “For several months now, we have seen customers taking advantage of meaningful dips that we see intraday or from one day to the next.”

Nickerson also said some inversion in the yield curve—where longer-term rates are lower than shorter-term rates—is driving activity.

“We're seeing more customers structure their hedges to take advantage of the shape of the yield curve by doing either forward-starting transactions or longer-dated transactions,” he said.

Nickerson added that Powell’s concurrent announcement that the Fed intends to be less transparent regarding its future actions will likely add to volatility.

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Rate Hikes Causing Lending Market Bifurcation

While loan activity among investment-grade borrowers remains strong, the Fed’s rate hikes are having an outsized effect on leveraged borrowers, according to Clarence Plummer, CoBank senior vice president, Capital Markets.

“There is a real bifurcation going on in the market right now where investment-grade borrowers continue to get competitive spreads and more leveraged borrowers are paying a significantly higher premium,” said Plummer. “The concern, of course, is the potential for a recession and the effect of lower growth on more leveraged borrowers.

“Spreads for investment grade borrowers have increased marginally as base rates—such as the fed funds rate and SOFR—have increased,” Plummer continued. “Spreads for the highly rated borrowers have gone from 140 to 160, to maybe 200 basis points. On the leveraged side, spreads have really increased, moving from 300 basis points to 350 or even 400 basis points.”

Plummer also confirmed that SOFR (Secured Overnight Financing Rate) continues to gain prominence among other index rates as an alternative to LIBOR. 

Market Focus

Agribusiness

Grain Prices Ease Slightly; Inflation and Strong Dollar Decrease Demand

While still near historically high levels, a noticeable decrease in grain prices has eased the financial pressure for some CoBank customers, according to Craig Smith, managing director, Capital Markets with CoBank. Combined with reduced spending during the mid-growing season, customers have been able to pay down some debt before the harvest season begins.

“We believe most farmers will look to sell at harvest,” said Smith. “However, we also expect the overwhelming majority to defer payment until the first week of 2023 for tax purposes. Farmers are in good shape from a cash standpoint, so they will be looking to defer the tax liability. The first week of January, though, could see a record amount of volume coming from CoBank and our partners to support grain and farm supply customers.
 
“Despite some relief, companies continue to manage a volatile environment,” Smith added. “We continue to see certain customers seek financial covenant relief as they navigate the effects of inflation on their profitability. The strength of the US dollar is also pressuring foreign sales, which are either worth less when converted to US dollars or less affordable, which is decreasing demand. The supply chain continues to provide challenges, as well.”

Smith also said that companies with exposure to retail consumers may find decreased demand for their goods as family budgets are stretched by high food prices, high energy prices and high energy usage amid the hot summer. 

Recent CoBank Capital Markets Activity

Dairy Farmers of America

Dairy Farmers of America

$200M Credit Facility
Administrative Agent & Lead Arranger

Owens-Brockway Glass Container, Inc.

Owens-Brockway Glass Container, Inc.

$2.8B Credit Facilities
Joint Lead Arranger & Joint Bookrunner

Greif, Inc.

Greif, Inc.

$515M Credit Facility
Lead Arranger

Communications

Smaller/Rural Market M&A Activity Remains Strong; States Scramble to Get Their Broadband Houses in Order

Commercial banks continue to have a strong appetite for term loans in the communications space. Driving their interest is robust M&A activity, including smaller markets and more rural areas, with infrastructure funds seeking to purchase platform companies to expand their fiber-to-the-home initiatives, according to Gary Franke, managing director, Communications Division with CoBank. 

The interest in smaller markets comes with the saturation of large markets, with multiple MSOs (multiple system operators) operating in the likes of Chicago, Atlanta, New York and other large regional hubs.

Also expanding activity in the communications space is the passage of President Biden’s infrastructure bill in late 2021. The bill includes $65 billion for the expansion of rural broadband through several different programs. The largest chunk of funds—$42.5 billion—is being provided through the Broadband Equity, Access, and Deployment (BEAD) program, which is being administered by the National Telecommunications and Information Administration (NTIA) of the U.S. Department of Commerce.

BEAD applications will ultimately be taken and funds distributed by individual state broadband offices, e.g., the State of Colorado Broadband Office. While the NTIA has provided general program guidelines, individual state requirements may differ.

”The $65 billion in broadband funding included in the Infrastructure Investment and Jobs Act is good news for rural America,” said Lennie Blakeslee, managing director, Communications Division of CoBank. “However, the impact of this nontraditional capital source is TBD.”  

Franke and Blakeslee expect that when BEAD activity picks up, there may be related match-funding and letter of credit opportunities. 

Recent CoBank Capital Markets Activity

Nuvera

Nuvera

$130M Credit Facilities
Administrative Agent & Lead Arranger

Teleguam

$180M Credit Facilities
Administrative Agent & Lead Arranger

Dobson Fiber

Dobson Fiber

$170M Credit Facilities
Administrative Agent & Lead Arranger

Power & Energy

The ESG Conundrum

The influence of ESG—environmental, social and governance factors—continues to rise and is becoming an increasingly important consideration in commercial lending. ESG considers how companies are managing their financial and nonfinancial risks related to their social responsibility obligations in these three important areas.

According to Bill Fox, managing director of CoBank’s Capital Markets Division, ESG has begun to influence loan pricing across the banking industry and is causing uncertainty within some commercial banks.

“Loan pricing is typically determined using a simple grid based on credit quality,” said Fox. “If the credit quality of a borrower improves, pricing may decrease. If the borrower’s credit quality deteriorates, loan pricing can rise, reflecting the increased risk to the lender.

“A new construct for ESG has been the introduction of sustainability-linked loans (SLLs), which have penetrated about 15% of the market,” Fox continued. “An SLL layers in a second pricing grid based on ESG-related key performance indicators (KPIs). This additional grid allows borrowers to get a loan pricing improvement if they achieve their predetermined ESG-related KPIs, regardless of the impact on traditional credit quality. Conversely, if the borrower fails to meet its ESG-related targets, pricing increases. This introduction of pricing changes based on non-credit metrics is new but appears to have gained market acceptance.”

Fox said that ESG is causing some controversy and uncertainty in the commercial banking industry where ESG groups inside of some banks have garnered the influence to outright deny loans to certain borrowers based on their ESG profile, sometimes excluding entire industries, even for borrowers proactively making ESG improvements. 

“As a mission-based lender, we know that many of our customers have an impact on the environment,” Fox concluded. “ESG is important and we are committed to it through our own sustainability focus. But we understand there must be a transition period for borrowers to become more environmentally and socially responsible, and we are willing to work with them as they navigate that process.”

Recent CoBank Capital Markets Activity

Dairyland Power Cooperative

Dairyland Power Cooperative

$215M Credit Facility
Administrative Agent

Allete

Allete

$170M Credit Facility
Doc Agent

Basin Electric Power Cooperative

Basin Electric Power Cooperative

$500M Credit Facility
Joint Lead Arranger

DISCLAIMER: The information provided in this publication is for informational purposes only and is not to be used or considered as investment research, a proposal, or the solicitation of an offer to sell or to buy or subscribe for securities or other financial instruments. Companies and transactions referenced in this publication are shown for illustrative purposes only, and the provision of such information is not a recommendation or endorsement in this context. Certain information contained in this publication has been obtained or derived from third-party sources, and such information is believed to be correct and reliable but has not been independently verified. While CoBank believes that factual statements in this publication, and any assumptions on which information in this publication is based, are in each case accurate, CoBank makes no representation or warranty regarding such accuracy and shall not be responsible for any inaccuracy in such statements or assumptions. Note that CoBank may have issued, and may in the future issue, other reports that are inconsistent with or that reach conclusions different from the information set forth in this publication. CoBank is under no obligation to ensure that such other reports are brought to your attention. Furthermore, the information may not be current due to, among other things, changes in the financial markets or economic environment, and CoBank has no obligation to update any such information contained in this publication. This publication is not intended to forecast or predict future events.

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