Question

From the point of view of a borrowing corporation, what are credit and repricing risks? Explain steps a company might take to minimize both.

Answer 1

Credit risk, sometimes termed roll-over risk, is the possibility that a borrower’s creditworth, at the time of renewing a credit, is reclassified by the lender. This can result in changing fees, changing interest rates, altered credit line commitments, or even denial. Repricing risk is the risk of changes in interest rates charged (earned) at the time a financial contract’s rate is reset.

Consider the following three different debt strategies being considered by a corporate borrower. Each is intended to provide $10 million in financing for a three-year period.

Strategy 1: Borrow $10 million for three years at a fixed rate of interest.

Strategy 2: Borrow $10 million for three years at a floating rate, LIBOR ?2%, to be reset annually.

Strategy 3: Borrow $10 million for one year at a fixed rate, then renew the credit annually.

Although the lowest cost of funds is always a major selection criteria, it is not the only one. If the firm chooses Strategy 1, it assures itself of the funding for the full three years at a known interest rate. It has maximized the predictability of cash flows for the debt obligation. What it has sacrificed, to some degree, is the ability to enjoy a lower interest rate in the event that interest rates fall over the period. Of course, it has also eliminated the risk that interest rates could rise over the period, increasing debt servicing costs.

Strategy 2 offers what strategy 1 did not, flexibility (repricing risk).It too assures the firm of full funding for the three-year period. This eliminates credit risk. Repricing risk is, however, alive and well in strategy 2. If LIBOR changes dramatically by the second or third year, the LIBOR rate change is passed through fully to the borrower. The spread, however, remains fixed (reflecting the credit standing that has been locked in for the full three years). Flexibility comes at a cost in this case, the risk that interest rates could go up as well as down.

Strategy 3 offers more flexibility and more risk.First, the firm is borrowing at the shorter end of the yield curve. If the yield curve is positively sloped, as is commonly the case in major industrial markets, the base interest rate should be lower. But the short end of the yield curve is also the more volatile. It responds to short-term events in a much more pronounced fashion than longer-term rates. The strategy also exposes the firm to the possibility that its credit rating may change dramatically by the time for credit renewal, for better or worse. Noting that credit ratings in general are established on the premise that a firm can meet its debt-service obligations under worsening economic conditions, firms that are highly creditworthy (investment-rated grades) may view strategy 3 as a more relevant alternative than do firms of lower quality (speculative grades). This is not a strategy for firms that are financially weak.

The borrowing corporation can minimize the credit and repricing risks by using the above said strategies.