The Pricing of Covenant Strength: The Lenderís Perspective

"The paper considers how UK lending institutions price covenant strength risk. At the outset of the research in March 2008, few could have forecast the level of turbulence that was to hit the financial markets in the autumn of 2008 and that by the end of the year the UK would officially be in recession. However, many had predicted that the UK commercial property market was overheating. The double digit returns of 2003 to 2006 told a story of capital value appreciation on the back of ìyield chasingî investors aided by cheap and available debt finance. Rental growth did not substantiate the yield compression that occurred over this period. The key question from a lending perspective is whether covenant strength risk was appropriately priced during this period. The paper reports on a series of face to face interviews with eight commercial and retail banks carried out during the summer of 2008. The lenders admitted that at the height of the market covenant strength risk was a relevant criterion in lending decisions, but that it was not the dominant factor. In pricing balance sheet loans, cash flow, lease length and re-letting prospects were more important considerations. Crucially, the emphasis appeared to be on short term trading volumes without fully appreciating the risk posed to the loan book during a down turn in the market. Stress testing loans is laudable provided the inputs reflect the reality of the market, during, and at the end of the loan period. In the securitised market the performance of the rating agencies, key in the pricing of fixed income securities, came in for criticism, and as positions unravel this is worthy of further research. The repricing of debt did occur from mid 2007, but the availability of cheap debt finance was undoubtedly a major reason for the overheating of the commercial market.""