BusinessCorporate FinanceAnalysis: ‘Double whammy’ on credit

Analysis: 'Double whammy' on credit

If you are a finance director trying to figure out the best way to raise investment capital for a board impatient for answers, the world is a different place since the collapse of Enron.

Where once it might have been easy to pick up that AAA status from the debt ratings agencies – indicating your company is a relatively safe bet for a loan – it’s now going to be a lot more difficult.

The environment has changed and the agencies, keen to avoid another Enron, want companies to work a lot harder to win top grades. With that being the case, companies will find it much harder to raise the cash they need.

Investment bank Goldman Sachs, reflecting on companies keen to issue bonds as a fund raising measure, says: ‘The proposed changes in the current policies could unintentionally restrict liquidity of issuers, especially those at the lower end of the investment grade spectrum.’

Changing the face of financing
It sounds bleak but it comes as a response from two agencies – Standard & Poor’s and Moody – whose proposals are likely to change the face of financing through the issue of commercial papers.

Credit ratings represent a company’s reputation in the marketplace and help investors gauge just how risky their investment in a borrower is likely to be. A company pays to be given a grade by independent analysts as a way of showing how strong its capacity is to pay back money it has borrowed. This is when companies pick up the grades – looking a lot like school grades – such as S&P’s which range from AAA to D, with plus and minus signs added to show the companies’ relative standing within the major categories (see box, right).

Companies rated between AAA and BBB are considered blue chip or ‘investment grade’ with a strong to adequate capacity to meet their financial commitments.

BB to CC rated companies are ‘junk grade’ or more vulnerable and investors run a higher risk with these.

Gauging a company’s health
S&P analysts scrutinise a wide variety of criteria, from a firm’s accounts to its managers and its competitiveness in the market. Anyone from an investment banker to Joe Public use the ratings as a gauge of a company’s health. Their ratings affect any borrower, including corporate entities like companies and banks, or government agencies, that issues bonds or other financial obligations.

But recent high-profile bankruptcies, including Enron and K-Mart, have made the agencies review their corporate rating procedures.

The demise of Enron, for example, caused S&P to downgrade the company repeatedly several times between November 2001 and January 2002. The corporation had enjoyed a BBB+ rating – between strong and adequate capacity to pay back its debts – for almost three years.

On 9 November, it was rated down from a BBB+ to a BBB- and rapidly descended to the status of junk bond until S&P gave up on it, giving it a D rating on January 22. As a result, rating agencies become more cautious to avoid getting egg on their face.

They will now focus more on liquidity and funding risks, comment more frequently after market events and earnings releases, scrutinise ratings that are dependent on disposals or recapitalisations more, and resolve rating reviews more quickly.

Less tolerance for bad ratings
The results of this, according to Goldman Sachs, could be less tolerance for companies that bag weak credit ratings. Weaker rated companies below BBB and companies with ‘contingent liabilities’ – such as those with underfunded pension schemes, environmental liabilities, and off-balance sheet debt – could also be more at risk.

With stricter controls companies will find it more difficult to get good ratings, causing them to have more difficulties selling their bonds. The bad news is they may simply have to pay more to sell bonds or commercial papers.

Issuers of bonds may find the market to be less liquid, less flexible and more costly, and investors may find the supply of bonds no longer meets their needs, according to Goldman Sachs. The recent tightened controls are unlikely to affect companies in the bond market as a whole, as the bond market is sector and company specific.

According to John Matthews, head of debt and ratings at investment bank Dresdner Kleinwort Wasserstein: ‘Bond markets may not wish to take certain companies surrounded by “event risk”, or penalise them for this higher investment risk through high spreads over the benchmark used for pricing. Sectors in the past 12 months that have experienced this type of pressure include telcos and auto.’

And companies below grade BBB – or investment grade – may also be more vulnerable, finding themselves stuck between a rock and a hard place.

Matthews says: ‘Companies that have their credit ratings downgraded will generally be required to pay higher interest expense on a new bond and may have to pay increased margins on existing bank loans which may have step-up pricing grids driven off rating downgrades.’

Other means of financing
Companies may have to look at other means of financing, such as securitisation, or even the equity market. He added in downgrading companies, agencies could hinder a company’s liquidity situation. And credit ratings don’t only influence the bond market, but also a company’s ability to borrow money from banks.

Lower ratings mean higher costs of interest. Banks will want more interest on their loans to companies with lower ratings. Lower ratings can negatively influence your share price.

A lower credit rating can also dictate whether banks are willing to lend a company money. Banks are likely to lend less money with stricter financial covenants and higher interest rates. Some companies who have ratings-linked pricing could also find that the interest rate of their bank loans will go up.

As a result of the downgrade a company’s financial flexibility decreases.

Matthews said: ‘As companies are downgraded into the low investment grade they face a “double whammy” – higher debt financing costs at a time when their ability to service debt has probably been weakened by a downturn in the company’s operating performance.’

The effects of stricter ratings have already affected some companies.

Ford was downgraded by Moody at the beginning of January, and chemicals company ICI underwent a discounted rights issue to better their credit standing. So firms will get less financing when they need it more and at a higher cost when their earnings are going down.

Stricter control
Goldman Sachs’ analysts say the stricter control could result in a debt market in which ‘a small group of exceptionally credit-worthy companies can borrow almost unlimited amounts at very aggressive rates, and a larger number of issuers have limited liquidity and relatively high borrowing costs.

Although companies may find themselves having to scramble for finance and attempting to retain higher ratings, analysts agree that overall, the move is not likely to make bond markets crumble, as commercial paper markets have proven to be resilient and adaptable.


Standard & Poor’s long-term issuer credit ratings

AAA – Extremely strong capacity to meet its financial commitments. The highest issuer credit rating assigned by Standard & Poor’s.

AA – Very strong capacity to meet its financial commitments. It differs from the highest rated obligors only to a small degree.

A – Strong capacity to meet its financial commitments but is somewhat more susceptible to changes in circumstances.

BBB – Adequate capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity to meet its financial commitments.

BB – BB, B, CCC, and CC ratings have significant speculative characteristics. BB is less vulnerable near term but faces major uncertainties; adverse conditions could lead to inadequate capacity to meet commitments.

B – More vulnerable than obligors rated BB, but currently has the capacity to meet financial commitments. Adverse conditions will likely impair the obligor’s capacity or willingness to meet its financial commitments.

CCC – Currently vulnerable, and is dependent upon favourable business, financial, and economic conditions to meet financial commitments.

CC – Currently highly vulnerable.

C – Highly vulnerable, where a company has gone into bankruptcy but the obligation is still paid.

D – Payment default given when payments are late or the company has filed for bankruptcy.


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