Rising borrowing costs increase debt-service burdens and reduce the capacity of many direct-lending borrowers to absorb operational disruption. As physical climate risks place further pressure on cash flow and financing needs, assessing adaptation and resilience readiness alongside modelled impacts can help direct lenders identify which borrowers are better equipped to maintain repayment capacity and recover operations.
Reduced margin for error
Almost all private credit loans are floating rate, with corporate direct lending loans generally priced at a spread over a reference rate such as SOFR or an equivalent benchmark. Therefore, borrowers face two pressures: benchmark rates can increase cash interest on existing loans, while wider credit spreads can make new borrowing or refinancing more expensive.
Recent developments in the US show how both pressures are bearing down on credit markets. Borrowing costs for the lowest-rated US corporate borrowers have reached 17 per cent, their highest level since May 2020. Although the recent bond sell-off has pushed government yields higher, wider credit spreads have driven most of the increase, as investors demand greater compensation for lending to weaker companies.
Direct lending borrowers are particularly exposed because their existing debt is predominantly floating rate. Morningstar DBRS expects private corporate credit to be affected “first and hardest” by rising rates, with higher interest expenses already placing pressure on interest coverage and cash-flow generation.
Interest-rate caps can provide protection, but hedging may cover only part of the debt or loan term. Cap costs also rise when expected rates or market volatility increase, making protection more expensive when borrowers value it most.
For leveraged borrowers, the result is reduced margin for error. When cash interest is high and refinancing more expensive, even a relatively small operational disruption can affect repayment capacity.
Compounding physical pressures
That reduced margin for error makes physical climate risk more credit-relevant. Acute events and longer-term climate changes can disrupt operations and damage assets, reducing the ability to service debt.
Companies reporting to CDP disclosed almost $3 billion of realised extreme-weather losses in 2025 and expect $714 billion of future impacts, with almost half of the identified risks expected to materialise within two years.
The pressure may not stop at the borrower’s assets. The Network for Greening the Financial System finds that physical impacts are already affecting inflation and output. By pushing prices up while reducing activity, these impacts can create difficult trade-offs for monetary policymakers, particularly as physical events become more frequent and severe.
The current El Niño provides a tangible example. It has caused an estimated ₱6.87 billion of agricultural damage in the Philippines and is expected to add inflationary pressure to food prices. The Bangko Sentral ng Pilipinas has factored El Niño into several policy decisions and raised its benchmark rate by a cumulative 0.75 percentage points since April amid wider inflationary pressures.
For leveraged, floating-rate borrowers, this creates a potential double hit: physical disruption can weaken the cash flow available to service debt, while related inflationary pressure can keep recovery costs, debt servicing and refinancing more expensive.
A financing feedback loop
Physical disruption can also create a financing feedback loop. Reduced cash flow and unexpected recovery costs (that are themselves subject to inflationary pressure) may increase a borrower’s need for additional capital just when benchmark rates and credit spreads are elevated. More expensive finance can then place further pressure on repayment capacity and leave less capital available to address the underlying vulnerability.
The loop is not inevitable. The challenge for direct lenders is identifying which borrowers are adequately planning and investing to contain operational disruption before it develops into a wider financing problem.
A&R readiness becomes credit-relevant
Adaptation and resilience readiness, or A&R readiness, can help direct lenders make that distinction. It assesses whether a borrower can manage and recover from physical impacts and adapt as those risks evolve.
Climate models remain essential for estimating exposure and potential financial impacts. But they cannot predict exactly when a severe event will occur during the loan or fully capture the effects on a borrower’s operations and dependencies. A low or inconclusive result may therefore indicate genuinely limited risk, or vulnerability that modelling cannot resolve with confidence.
Considering A&R readiness alongside modelled impacts adds company-level evidence. Does the borrower understand how physical risk could affect operations and cash flow? Has management identified critical dependencies, such as key sites, suppliers or infrastructure? Are its measures to reduce disruption and support recovery credible, funded and reflected in the business? IIGCC’s Climate Resilience Investment Framework and Adaptation & Resilience: Tool for Engagement provide useful prompts for examining this.
For borrowers with material physical exposure, a low or inconclusive modelled result should not automatically end the assessment. Bringing A&R readiness into normal credit analysis can help direct lenders distinguish genuinely limited risk from vulnerability that has not been fully captured, while giving borrowers a clearer financial incentive to reduce that vulnerability.