Rating Trigger

A Rating trigger is a covenant in a bond issue agreement or financial contract that obliges the borrower to maintain its own credit rating above a certain rating threshold and allows for certain actions to be taken by one or the other party if the rating is downgraded.

There are three categories of rating triggers:

• The first category obliges the borrower to provide additional collateral for its obligations;
• The second category provides for an increase in the interest rate to be paid by the borrower to mitigate the lender for higher risk;
• The third category reduces the period until the repayment of obligations by the borrower.

Features:

• It can release bond holders from certain obligations specified in the agreement;
• In exceptional circumstances it may activate a rating-based put option that requires the borrower to repurchase the debt from the lender;
• It may result in automatic borrower’s default;
• A trigger event may include one or more thresholds or may be combined with other risk events;
• A trigger event may not necessarily be a downgrade;
• As a rule, debt obligations with a rating trigger are undertaken by issuers with low risk and operational flexibility.

Advantages:

• Presence of a rating trigger in the agreement protects the lender from an increase in the risk level of the borrower;
• Rating trigger reduces the cost of debt capital;
• Rating trigger monitoring is simple and does not require extra costs: the lender only needs to monitor compliance with the terms and conditions through the use of rating agency data and the financial press; the borrower’s internal monitoring and conducting their own audit is not required.

Disadvantages:

• In case of an adverse rating event, the rating trigger intensifies the borrower’s need for liquidity at the very moment when its credit risk is higher, which increases the probability of the borrower’s default;
• Rating triggers are applied to borrowers characterized by a high level of risk, more vulnerable to the growth of payment obligations and associated discredit as a result of the trigger activation;
• Repeated rating events may follow a loss of liquidity caused by the activation of the initial rating trigger, which may lead to the borrower’s default.