Corporate bond issuances are becoming increasingly popular in light of the lending freeze by banks. But in 2012 how many credit ratings does a corporate need to attract investors?
Today’s business landscape is an unforgiving one. An economic crisis persists in Europe. Bank lending remains restricted. It is understandable, then, that treasurers are thinking outside the box when it comes to securing adequate levels of finance.
Over the last six months, an increasing number of corporates have turned to the capital markets as an alternative source of funding. In late 2011, for example, the UK retailer Wm Morrison issued a £400m 12-year bond to record demand. It was shortly followed by Petrobras, the Brazilian state-owned energy company, which launched a successful bond auction of £700m to UK investors.
“The credit crunch has meant that available financing from the banks is tightening,” says Vinod Parmar, Group Treasurer of Ladbrokes, one of the world’s leading betting and gaming companies. “If you are going to keep your leverage at the same sort of levels compared to pre-credit crunch, then you have got to find new sources of funding. Corporates have started to be interested in whether they can issue and what the processes they have to go through are.”
“If you are going to keep your leverage at the same sort of levels compared to pre-credit crunch, then you have got to find new sources of funding. Corporates have started to be interested in whether they can issue and what the processes they have to go through are.”
“There has definitely been an increase in demand,” agrees Richard Anthony-Smith, Senior Director of Fitch’s EMEA Business & Relationship Management. “In western Europe corporates are anticipating that banks will deleverage further over the coming period, and that this will reduce spending.”
“So as a consequence corporates are taking ratings now to be able to source alternative funding from the capital markets, through bond issuance. This is easier to do so when they have ratings in place,” Anthony-Smith adds.
With by no means insignificant price tags attached to such ratings (the average corporate would be looking at anywhere from £10,000 per annum in fees upwards), the question is how many ratings are really necessary, if any?
What’s the magic number?
It is true that many companies issuing corporate debt manage to do so with one credit rating. Indeed, several issue corporate debt without holding a single credit rating to their name.
“Corporates are taking ratings now to be able to source alternative funding from the capital markets, through bond issuance.”
Take John Lewis for example. Despite having no credit rating, the UK retailer successfully launched a 6.5% five-year corporate bond in March 2011. Its success can however be attributed to the recognition of its brand and the company’s market share. Investors know what they are buying. Not all companies have these advantages at their disposal though, making ratings more of an imperative.
And even major corporates that have a history of successful bond launches without ratings have solicited ratings recently. In March 2012, Heineken announced it was given investment grade crediting ratings by Standard & Poor’s and Moody’s. It was the first time in the company’s 150 year history that it turned to credit ratings. According to a statement released by René Hooft Graafland, “The award of these credit ratings underlines our commitment to transparency and diversification of our funding sources.”
“In March 2012, Heineken announced it was given investment grade crediting ratings by Standard & Poor’s and Moody’s. It was the first time in the company’s 150 year history that it turned to credit ratings.”
It is noteworthy that given the prevailing market uncertainty, the international brewer obtained two ratings. Heineken is not the only company to seek out a double rating either. Carlsberg Breweries, National Express, Alliance Oil Company and Hammerson have all sought out a second ‘stamp of approval’ recently.
The ratings trap
While credit rating agencies shine a spotlight on a corporate for the entire business world to see, this can be a mixed blessing. Take the chairman of Sears Holding Company, Edward Lampert, who gained notoriety after he lashed out at the ‘simplistic analyses’ of the ratings agencies. His outburst followed a decision by ratings agencies to downgrade his company, further undermining business difficulties.
Nevertheless, a credit rating is for many companies a gateway into debt capital issuance. “At the end of the day all companies – whether they are banks or corporates – are in the business of competing for capital. It is as simple as that,” says Cheryl Sunderland, Vice President, Financial Markets, Shell International Ltd. “From a structural viewpoint, the credit rating agencies fulfil a crucial role. What they do is establish a framework which really should be a basis for comparability across companies and across different kinds of markets to help investors make decisions about that competition for capital.” Shell is one of the few corporates left standing with a AA long-term credit rating by Standard & Poor’s and Moody’s.
The relevance and sway of credit rating agencies has increased substantially since the onset of the Eurozone crisis. S&P, Moody’s and Fitch, commonly known as the ‘Big Three’, are seldom out of the headlines as they downgrade one Eurozone sovereign after another. For corporates that have or are seeking ratings, they must strive – now more than ever – to establish a transparent relationship with the ratings agency. This duty often falls to the group treasurer or the chief financial officer.
The majority of ratings agencies interweave quantitative methods and qualitative considerations when assessing a corporate’s credibility. Key financial data – such as profitability measures and credit ratios – both confidential and private are sent by the corporate to a ratings agency.
Quantitative models are then used to process the data, with ratings agencies looking at business risk and financial risk in particular. The results are combined with qualitative judgements depending not only on the economic and political situation of the country in which the business is located, but also on the ratings agency’s understanding of the corporate itself.
Agencies can also choose to place a corporate on watch (positive or negative) in light of anticipated events, ie the release of Q1 results or rumours of a company takeover.
Given that a single credit rating can act as a pathway into the capital markets though, will an additional credit rating really open up the highway? There are some who certainly think so. According to Anthony-Smith, there are two benefits to be drawn from eliciting an additional rating. “The market appreciates a second opinion – a comparative opinion to what they have now,” he says. “That is a key benefit. The other advantage is that some asset managers have their own internal guidelines stating that they can only invest in corporates that have two ratings.” Businesses seeking an additional stamp of approval, then, can take advantage of the incremental benefits that come with a second credit rating.
Ladbrokes has credit ratings from all of the ‘Big Three’ rating agencies. This is partly due to historical reasons, when the group changed significantly at the end of the 1990s after some major acquisitions. The gambling company was in need of capital funding. Although it already had a rating from Fitch, it acted on the advice of its banking counterparties and sought out two additional ratings from Standard & Poor’s and Moody’s.
“Ladbrokes has credit ratings from all of the ‘Big Three’ rating agencies. This is partly due to historical reasons, when the group changed significantly at the end of the 1990s after some major acquisitions. The gambling company was in need of capital funding. Although it already had a rating from Fitch, it acted on the advice of its banking counterparties and sought out two additional ratings from Standard & Poor’s and Moody’s.”
“I am not that sure if I have that much more benefit by having three credit ratings,” says Parmar. “But a lot of investors have a minimum criterion that a bond or a corporate has to be rated by two agencies – and one of those agencies has to be Standard & Poor’s or Moody’s effectively.”
With security comes a price
But acquiring a credit rating requires time, resources and money. Not only is there the annual fee to be paid, companies also have to take into account the issuance fee. Every time a corporate issues a new bond, it has to pay a certain percentage in terms of basis points on the issue amount. “It is not cheap. It does mount up,” said a European treasurer who preferred to remain anonymous.
But shouldn’t corporates be willing to pay the extra price to assure funding in uncertain times? Other treasurers are not so sure, citing the buoyant condition of the capital debt issuance markets in both Europe and America. Why seek out an additional credit rating when investor demand is already quite strong?
Indeed, perhaps the biggest paradox of the current sovereign debt crisis is that the corporate debt market has emerged the main beneficiary of the economic fallout. At first glance, of course, turmoil in the fixed income market should have little immediate impact on the corporate world. But look closer and a more nuanced picture emerges. Investors are turning to high investment-grade corporate debt in place of erstwhile ‘safe’ sovereign bonds.
Since the beginning of the year, European corporate debt issuance has jumped by 83% compared to the same period in 2011, according to data released by Thomson Reuters in February. Companies from Germany, France and the United Kingdom are the main winners, accounting for 69% of all debt issuance.
“Investors are looking around. They still need to look for a decent quality coupon and get some return,” says Carsten Gottschlich, Head of Corporate Treasury at Symrise, a global supplier of fragrances and cosmetic ingredients. “You could buy German bunds, but then you don’t get any return at all. Investors are going for a better coupon. German corporates, for example, are very strong and very solvent.”
“You also make yourself increasingly independent from banks,” notes Gottschlich. “You diversify your funding landscape by having several more lending institutions available, rather than having just one bank. Corporate bond markets are very attractive. They are currently very liquid.”
Across the Atlantic, American corporate bonds are also experiencing strong demand. Barclays announced in late February that the average yield on US corporate bonds has sunk to a record low of 3.34%. Investors on both sides of the pond are lapping up corporate debt. A single credit rating, temporarily at least, should be enough to tap into this demand.
Of course, there is logic behind this development. Bank lending is no longer as buoyant as it used to be. Financial institutions continue to deleverage, and impending Basel III regulations means capital ratios will be bumped up to ward against future economic crises. Corporates know that the days of plenty will not be returning anytime soon. So they turn to the capital markets. Furthermore, as a result of the sovereign debt crisis, corporate debt is no longer perceived to be as risky as it used to be. There is now both a supply and demand for corporate debt.
No easy answer
In the last six months it has become far easier for corporates to issue bonds. This reduces the incentive for corporates to obtain an additional credit rating. “If you are successful with one, why go get another?” asks Parmar. “The only downside of not getting another is that other agencies might rate you differently and give you a better rating. So you may be missing an opportunity by not going through that process.”
But how long will the bull market last in Europe and the United States? Investor sentiment is liable to swing back and forth. A simple answer will not suffice. The treasurer must carefully weigh the pros and cons of an additional credit rating. Are you thinking of stepping into the corporate debt market for the first time? Two credit ratings may be the best option. “Generally the model is that investors prefer two ratings,” says Parmar. But of course there are exceptions to any rule.
Larger corporates that benefit from brand recognition and dominant market share can do without credit ratings. But the recent example of Heineken is quite telling. Despite a history of successful corporate bond issuance, the drinks corporate sought out two credit ratings. This can partly be attributed to fears of an uncertain investment environment. But bank lending is also difficult to come by, and how long the debt capital market boom will continue is anybody’s guess.
In meantime, however, many corporates are playing it safe. Demand for credit ratings is increasing. And there is no sign of that changing anytime soon.