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Definition of Default
Capital Intelligence (CI) considers a default to have occurred when:
- An issuer fails to pay a material sum of principal and/or interest on a financial obligation in accordance with its terms;
- An issuer files for bankruptcy or similar protection from creditors – unless there is reason to believe that debt service payments will continue to be made in a timely manner;
- An issuer restructures (reorganises), reschedules, exchanges or in some other way renegotiates a debt instrument and the following apply:
- There is an adverse change to the terms of the original debt agreement; AND
- The renegotiation or exchange is considered by CI to be distressed or coercive.
Adverse changes to the terms of the original debt agreement may include the following:
- A reduction in the principal amount or coupon/ interest rate.
- An extension of the maturity date or loan tenor.
- A reduction in seniority or a substantial weakening of covenants.
- A cash tender for less than par.
- A decrease in the frequency of payments (e.g. to bullet from amortising).
- Swapping debt for equity or hybrid instruments.
A debt renegotiation or exchange is deemed to be distressed or coercive when one or more of the following apply:
- The issuer would, in CI’s opinion, be unable to honour its obligations under the original debt agreement due to its weak financial position.
- The issuer is unwilling to honour its obligations to those investors who choose not to participate in the renegotiations or exchange offer.
- The issuer threatens, explicitly or implicitly, to miss payments, weaken the governing indenture or to seek bankruptcy should the terms of its proposal or exchange offer not be accepted.
From a credit rating perspective, default is a de facto rather than a de jure concept and is determined independently of any legal proceedings by creditors. Moreover, technical defaults, such as covenant violations or the triggering of cross-default or cross-acceleration provisions clause, do not in themselves constitute a default under CI’s definition, provided that the obligation is being serviced in a timely manner.
Default under the first two categories (1 and 2) is relatively clear-cut and easy to establish for most types of financial obligation. The last category of default is more subjective and is determined on a case-by-case basis.
In most cases, the reason for an issuer undertaking a debt restructuring or exchange that results in losses (including in net present value terms) for creditors will be key to determining whether or not a default rating should be assigned. A debt renegotiation or exchange offer that involves adverse changes to the terms of the original agreement is more likely to attract an issue rating of ‘D’ when it is evident that the issuer is pursuing such changes because it is unlikely to be able to service part or all of its outstanding debt obligations over the near to short-term. In such cases, creditors may be willing to accept less than the original amount owed because they anticipate greater losses in the event of a conventional default.
CI recognises that debtors and creditors may have an incentive to conceal occurrences of default in certain circumstances and consequently CI may consider a debt renegotiation or exchange to be distressed or coercive even if the parties involved describe the action as “voluntary”.
Default, Selective Default, and Regulatory Supervision
When an entity defaults on an instrument rated by CI, the issue rating assigned to that instrument is lowered to ‘D’.
An entity’s issuer rating is lowered to ‘SD’ (selective default) when it fails to service one or more of its financial obligations (rated or unrated), but CI believes that the default will be restricted in scope and that the entity will continue honouring other financial commitments in a timely manner. An issuer rating of ‘D’ is assigned when an entity defaults on an obligation and is expected to default on all, or nearly all, of its other financial obligations.
Reflecting the special nature of financial institutions, CI assigns an issuer rating of ‘RS’ (Regulatory Supervision) to banks that are placed under the supervision or administration of the authorities due to their weak financial condition. An ‘RS’ rating signals to investors the precarious repayment capacity of the institution and the extremely high likelihood of default absent regulatory forbearance and/or financial assistance from the state.
Events that Would Probably Not Constitute a Default
The following are unlikely to trigger a downgrade to a default rating, especially if conducted by an entity with a reasonably strong credit profile:
- An exchange offer or issue maturity extension conducted well in advance of the original maturity date and where creditors receive compensation in the form of amendment fees, a higher interest rate, a beneficial change in the instruments seniority, or an increase in, or the introduction of, security interest.
- A debt buyback operation in the open market, where any difference between the price of the instrument being repurchased and its par value is a reflection of market-related risks, such as interest rate volatility, and holders of the debt are not forced into accepting a monetary loss.
- An exchange offer or similar transaction conducted well in advance of the maturity date where creditors voluntarily agree to exchange existing obligations for new obligations at below par, and where the offering/exchange price reflects market conditions, including interest rates, rather than concerns about the creditworthiness of the rated obligor.
- The renegotiation of a bilateral bank loan conducted in the normal course of business, unless there is clear evidence that the renegotiation is distressed.