Revolving credit facilities may be availed for a number of different reasons – for operating lines, back up lines, to reimburse letters of credit (LC) issued to subsidiaries, etc.
There is an aggregate commitment amount that may be drawn in part or full during the life of the facility. The borrower has the right to choose when to draw the amount and when to pay back the loan during the available period. A number of transaction costs may be assessed including a commitment fee on the undrawn portion of the facility, a participation fee on the LC exposure, a penalty fee if the loan is prepaid before the end of an interest payment period.
The loan is also subject to the risk of default of the borrower. Usually, in the period prior to default, revolver draws may increase above the normal anticipated rate of the borrower, as credit in the market becomes more expensive.
While a number of elements in the valuation process are similar to those mentioned earlier for Term B loans there are some significant differences.
The credit agreement will contain details of the total loan amount, start and maturity dates, types of borrowings offered (e.g. base rate or Eurodollar rate loans), the frequency of interest payments, fees payable if any, applicable margins applied to variable interest rates, etc.
A risk free term structure, such as the US Treasury Daily yield rates is needed both for determining discount rates as well as for the calculation of future cash flows.
Historical time series data for the other reference rates mentioned in the agreement should also be obtained. Data may be available from a number of public domain sources, or may be obtained from the client. This data will provide an estimate of the average spread of these rates over the US Treasury rates.
Market yield and credit spread information on loans or bonds of similar credit standing would also be of use.
Recent ratings action reports by eligible ratings agencies (e.g. Moody’s, S&P, A.M. Best, NAIC) will inform of the current level of creditworthiness of the company as well as its debt. Information on loss severities (LGDs) and/ or recovery rates, default rates, transitions and credit migrations should also be obtained if available.
Certain loan structures may link the applicable margin or fees to certain performance or leverage ratios of the company. Financial statements available public or from the entity itself may be obtained to calculate these ratios and assign the correct spread/ fee.
Drawn/ undrawn balances data
The borrower has the right to draw a credit line whenever needed during the life of the loan. The normal usage rate depends on what the facility is intended for and hence the best information on the anticipated usage rate should be obtained from the borrower.
The borrower may also provide information on draws from undrawn balances during periods of stress or the data may be imputed from the difference in the contractual cost and market cost for obtaining additional credit. For this purpose, credit default swap spreads for the entity or yields on commercial paper issued by the entity may be used.
Interest rate term structure
The risk free term structure is obtained in order to determine the discounted rates used for the present valuing future cash flows. The par term structure is bootstrapped to get the zero coupon and forward rates as of the valuation date. The zero coupon rate is used along with the credit spread mentioned below to discount future cash flows. The forward rates determined may be used along with appropriate spreads and applicable margins to project future cash flows.
Market yield data for loans or bonds of similar credit rating will give an estimate of the credit spread as of the valuation date. An assumption may be made that the spread will remain constant over the life of the loan or may vary based on modelled credit migrations.
Default rates may be assessed from data gathered on the most recent rating action as of the valuation date. It may be assumed as static over the life of the loan, or may be modelled.
Data for recovery rates may be collected from market sources.
Normal usage rate
The normal usage rate of the revolver may be provided by the client as they are in the best position to inform of the utilization. A static utilization rate may be based on the rate communicated by the client or the usage rate may be modelled based on the opportunity cost of credit available in the market.
Additional draws rate
Draws on revolvers tend to increase as the creditworthiness of the entity declines. A static assumption may be assumed or the usage rate may be modelled based on the opportunity cost of credit available in the market.
The prepayment rate assumption may be ignored if the cash flows of revolver repayments are structured in such a manner to resemble a deterministic one period recurring loan in the valuation model. In particular it may be assumed that any amount withdrawn at the beginning of any interest period is prepaid in full at the end of the interest payment period, and then redrawn again at the start of the next interest period.
3. Cash flows
For the revolving credit facility cash flows include the revolver amounts drawn, the fees payable and the accrued interest on the outstanding revolver balance at the end of the interest payment period.
There is additional uncertainty as the option to draw lies with the borrower. Assumptions to the amount drawn and the timing of such a draw and repayment prior to the maturity, together with defaults will impact the contractual cash flows of the facility. For example, it may be assumed that at the beginning of each interest payment period an amount equal to the aggregate commitment times the normal usage rate is drawn. Accrued interest will apply to this amount and will be payable at the end of the period. Fees will apply to the drawn / undrawn balances and will be payable either at the beginning or end of the period. The drawn balance will be repaid in full at the end of the period. The process will be repeated for each subsequent period.
Defaults may be assumed to occur at the end of the period and comprise of a repayment of the full outstanding beginning of period balance together with accrued interest & fees payable for the period, adjusted for the proportion of this amount that will remain unrecovered because of the default event. Further, additional draws due to anticipated default, adjusted for loss severity will be deducted at the end of each period.
4. Valuation Model
The valuation model projects the cash flows mentioned above for each future time step, including the valuation date and the maturity date of the loan. It then discounts these cash flows to derive a single value on the valuation date. The discount factor considers not only the time value of money, i.e. interest (zero coupon rate plus credit spread) but also the probability of default.
5. Results & Stress Testing
The results obtained are fair values measured with significant unobservable Level 3 inputs as of the valuation date. These results should be stressed and sensitivity tested for the major assumptions used in the model including the interest rate, credit spread, default rates, usage rates, transaction costs, etc.
- Building a credit risk valuation framework for loan instruments – Scott Aguais, Larry Forest and Dan Rosen – Algo Research Quarterly, Vol. 3, No. 3, December 2000, pp. 21–46.
- Statement of financial accounting standards No. 157 – Fair Value measurements – FASB – 2010
- Credit exposure and valuation of revolving credit lines – Robert A Jones & Yan Wendy Wu – 19 July 2009
- Questions you should be asking about Senior Secured Loans – Joe Lemanowicz – May 2011
- A one-parameter representation of credit risk and transition matrices – CreditMetrics Monitor Third Quarter 1998 (pp.46 -58)
- Ratings symbols and definitions – Moody’s Investor services – May 2016