Rate Rise Continues; Recession Risk Hits Leveraged Borrowers

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. 

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. 

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.”