CHICAGO--(BUSINESS WIRE)--Fitch Ratings has affirmed National Rural Utilities Cooperative Finance Corp.'s (CFC) Long-Term Issuer Default Rating (IDR) at 'A'. The Rating Outlook remains Stable. A full list of rating actions follows at the end of this press release.
KEY RATING DRIVERS
IDRS
CFC's ratings continue to be supported by its unique competitive position as a cooperative, its very strong asset quality over time, good funding diversity and on-and-off balance sheet liquidity resources. CFC's higher leverage relative to comparably rated peers, its modest earnings profile, its reliance on wholesale funding sources and its limited ability to raise third-party equity remain rating constraints over the near to medium term.
CFC has meaningful and unique franchise strengths within the electric cooperative lending space that support its high rating. Fitch estimates that CFC consistently garners approximately 20% of the total electric cooperative lending market. Moreover, CFC continues to strengthen its franchise, demonstrated by the number of borrowers that use CFC exclusively for borrowing needs. The company has disclosed that the number has grown from 190 borrowers at fiscal year-end (FYE) 2014 to 207 at FYE15.
CFC's rating is also supported by its strong asset quality and very low credit losses over time. CFC's primary credit exposure is to rural electric cooperatives that provide essential electric services to end-users. Many borrowers are unhindered from passing along increased input costs to the end-customer, resulting in a stable operating environment for the rural electric cooperative space. Moreover, over 90% of CFC's loan portfolio by dollar volume is secured by senior liens. Over CFC's 46 years of operations, the company has only had 16 electric cooperative borrowers default with net write offs totalling $86 million pointing to not only a strong, stable lending space but also solid credit risk management.
Fitch's expectation that management will maintain its current focus on CFC's core members is incorporated into today's affirmation and the Stable Outlook. Management has significantly reduced exposure to telecommunications entities. CFC's exposure to rural electric cooperatives (both on the distribution side and the generation and transmission side) represented around 98% of the outstanding loan portfolio at 3Q16. Loans to telecommunication entities, which in the past were the primary driver of elevated nonperforming assets (NPAs) and credit losses, represent less than 2% of the portfolio. While this strategic focus naturally results in a significant industry concentration, the relative stability and strength of the electric cooperative industry adequately offsets the risks, in Fitch's view.
CFC is highly dependent on capital markets funding, albeit at lower levels than in the past. However, CFC's ability to maintain adequate, cost-effective funding in various rate and credit cycles as well as management's strategy to diversify the company's funding base over time supports the company's current rating. Management has been able to establish funding sources with the Federal Financing Bank (FFB) and Farmer Mac to complement its member-provided funding. CFC also has $3.3 billion in line of credit commitments from a syndicate of commercial banks that could be used in the event that its commercial paper program comes under stress. Moreover, approximately 29% of CFC's loan portfolio is unencumbered and could be pledged to support further funding from the FFB or Farmer Mac, if necessary. Nonetheless, Fitch recognizes that CFC's ability to access the capital markets at reasonable costs is heavily tied to its perceived creditworthiness.
Earnings and profitability, while very low compared to similarly rated financial institutions, are adequate for CFC's risk profile and structure. As a cooperative, CFC's mission is not to generate large profits but instead to cover its cost of funding, its cost of operation and its credit costs in addition to generate a modest profit. This is evidenced by CFC's lack of risk-based pricing with the benefits of its low funding costs passed along to its member borrowers. Moreover, CFC's lack of hedge accounting for its derivatives creates quarterly earnings volatility. Thus, in its analysis of CFC's earnings and profitability, Fitch places a greater emphasis on the company's adjusted net income and adjusted TIER measures, which excludes derivatives gains and losses.
These measures have been adequate and in-line with Fitch's expectations. CFC's adjusted TIER, which excludes the impact of unrealized derivative forward fair value gains and losses and includes periodic cash derivative settlements, through 3Q16 was 1.24x, which was up from 1.21x through 3Q15. Net interest income growth of 5% relative to the year prior was due to higher loan balances and the absence of impairment charges related to a legacy foreclosed asset which drove the year-over-year improvement.
Adjusted TIER is a benchmark included when determining compliance with CFC's covenants tied to its revolving credit lines. Under the covenant, CFC must maintain an average adjusted TIER of greater than 1.025x over a six-quarter period and it must maintain an adjusted TIER of greater than 1.05x for the most recent fiscal year in order to distribute patronage capital to its members. CFC's adjusted TIER results have far exceeded these minimums over recent periods. Given the company's strong credit quality and ability to adequately price loans, Fitch expects adjusted TIER to remain strong and in excess of its 1.1x target over time. This expectation is reflected into today's affirmation and the Stable Outlook.
Leverage remains above similarly rated bank and non-bank financial institutions. Fitch gives CFC's subordinated deferrable debt and member capital securities 50% equity credit based on Fitch's 'Treatment and Notching of Hybrids in Non-Financial Corporates and REIT Credit Analysis' criteria. If CFC's loan and guarantee subordinated certificates (LGSCs), which can be used to absorb credit losses, are considered 100% equity, Fitch calculates debt to equity of 9.1x at 3Q16, up from 7.9x at FYE15. The increase is primarily the result of loan growth and GAAP equity declining due to a net loss experienced during the current fiscal year. The net loss includes the impact of the derivative fair value change mentioned above. Fitch's calculation of leverage, in particular the treatment of the deferrable debt, member capital securities, and CFC's LGSCs in its consideration of equity, is a variation to Fitch's Global Non-Bank Financial Institutions criteria, as noted earlier. These adjustments are considered variations to the criteria and are incorporated in the assessment of CFC's rating due to its status as a cooperative and the unique nature of its capital structure.
Importantly, CFC's bank line of credit covenants strip out derivative fair value changes and all member-held capital and debt and subordinated deferrable debt are given 100% equity credit when determining the company's adjusted leverage. When making these adjustments, CFC's 3Q16 debt to equity stood at 6.31x, still elevated from 5.93x at FYE15. However, in April 2016, the company issued $350 million in subordinated deferrable debt. Fitch estimates that adjusted debt to equity at FYE16 will be under management's stated target of 6.0x.
As a cooperative, CFC's capital generation primarily is derived from its members (through member-owned investment vehicles) and retained earnings, a rating constraint in Fitch's view. This is especially important given that CFC's earnings are low due its mission-oriented business model. Still, management and the board have shown the willingness to improve earnings retention in order to improve the quality of CFC's capital and lower its leverage by adjusting the company's patronage policy in 2009.
SENIOR SECURED DEBT
Ratings assigned to the senior secured notes are notched up by one notch from CFC's IDR given the strong collateral backing such notes and the likely strong recovery prospects for debtholders. CFC's collateral trust bonds (CTBs) are backed by high performing mortgage notes with strong, stable underlying hard assets and substitution requirements in the event of collateral underperformance. Recoveries in the utility space have been high for CFC over time, a key consideration when determining notching for the secured debt.
SUBORDINATED DEBT AND OTHER HYBRID SECURITIES
Ratings assigned to the subordinated deferrable debt (SDD) are notched down by two notches from CFC's IDR. As noted above, when assessing CFC's SDD for equity credit and notching, Fitch utilized its 'Treatment and Notching of Hybrids in Non-Financial Corporates and REIT Credit Analysis' (Feb. 29, 2016), due to the unique nature of CFC's business model which exhibits some non-financial institution characteristics. Fitch views CFC's SDD has a hybrid capital instrument given that it can defer interest payments for up to five years (10 payments) with payments accruing over time.
The instrument is given 50% equity credit and 50% debt treatment in Fitch's analysis. SDD would be senior to all member-held instruments but subordinate to senior secured and senior unsecured debt levels. Still, Fitch believes CFC's SDD would have higher recovery prospects than bank-issued hybrid debt thus warranting narrower notching than a traditional hybrid capital instrument
RATING SENSITIVITIES
IDRS
In Fitch's view, CFC's ratings are solidly placed at their current levels with little upside in the near to medium term. However, ratings could be positively influenced over the long-term by a continued build-up of GAAP equity such that leverage comes in line with comparably rated peers. Moreover, Fitch would likely view a more durable funding structure (i.e. less wholesale funding reliance) over the long term as a positive rating development and could result in positive rating action provided credit quality remains strong.
Conversely, ratings continue to be strongly sensitive to CFC's focus on its core members. If there is a perceived drift in focus, evidenced by an increased level of lending to sectors outside of its rural electric member base, negative rating action would be likely. Furthermore, ratings could be adversely impacted by a reduction in the level of earnings retained leading to increased leverage due to a change in capital policies. Fitch would also view a decrease in liquidity support relative to funding obligations, such as CFC's bank lines being significantly reduced or cut, as a negative credit rating driver.
Lastly, Fitch notes that there could be challenges experienced by the electric cooperative space over the long-term road due to potential legislative changes relating to environmental issues. Fitch likely would view a spike in nonperforming loans within CFC's core loan book due to financial stress within the sector indicating an inability to adapt to new legislation as a credit negative, thus ratings would likely be adversely impacted.
SENIOR SECURED DEBT
CFC's senior secured debt ratings are broadly sensitive to the same considerations that would affect its IDR.
SUBORDINATED DEBT AND OTHER HYBRID SECURITIES
CFC's hybrid debt ratings are broadly sensitive to the same considerations that would affect its IDR.
Fitch has affirmed the following ratings:
National Rural Utilities Cooperative Finance Corp.
--Long-term IDR at 'A'; Outlook Stable;
--Short-term IDR at 'F1';
--Senior secured at 'A+';
--Commercial paper at 'F1';
--Subordinated deferrable debt at 'BBB+'.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria
Global Non-Bank Financial Institutions Rating Criteria (pub. 28 Apr 2015)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=865351
Treatment and Notching of Hybrids in Non-Financial Corporate and REIT
Credit Analysis (pub. 29 Feb 2016)
https://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=878264
Additional Disclosures
Dodd-Frank Rating Information Disclosure Form
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Solicitation Status
https://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=1004768
Endorsement Policy
https://www.fitchratings.com/jsp/creditdesk/PolicyRegulation.faces?context=2&detail=31
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