Let’s be honest. Few treasurers have the time to become experts in the minutiae of the rating agencies’ methodologies. But treasurers do require at least general understanding of the basic principles involved. Now with the ‘Big Three’ ratings agencies promising more transparency around how they reach their decisions, those fundamental principles are evolving. In this feature, we bring treasurers up-to-speed with the latest developments.
For corporates looking to issue debt on the capital markets, an investment-grade credit rating is not entirely essential. But with many institutional investors prohibited from investing in all but the safest credits, having those three A’s next to your company’s name sure does help.
If you want to make absolutely sure that your company receives the rating it deserves, it helps to have an understanding of how the likes of Moody’s, S&P, and Fitch work when scoring the creditworthiness of corporate issuers. Most treasury teams will be familiar with the corporate credit ratings grids (see Chart 1) used by the ‘Big Three’ ratings agencies, yet their knowledge of the methodologies behind a rating, and the factors that can trigger a change can often be patchy.
Do you, for example, fully understand how M&A activity is treated by the ratings agencies? If a corporate announces an opportunistic acquisition, against a previously declared strategy of organic growth, how will that impact the credit rating? With Fitch’s methodology, this kind of event would be excluded from the prior rating, and would “typically generate a rating review based on materiality and impact, depending on the funding mix and cost,” according to the agency.
One of the problems with such ambiguities is that they do not tend to breed trust or confidence, two things the agencies have been desperately trying rebuild in recent years.
As we all know, the Big Three agencies came in for robust criticism in the wake of the financial crisis for their ratings of collateralised debt obligations (CDO) – part of a family of instruments Warren Buffett once described as “financial weapons of mass destruction” that were, according to one academic, responsible for $542 billion in write-downs at financial institutions between 2007 and early 2009.
And while many companies continue to attach significant weight to the agencies’ judgement post-crisis, others are reluctant to trust them fully. “The ratings agencies are starting to build up credibility again and they have made great strides, but some corporates still look at them with hesitancy,” says John Coon, Global Treasury Manager at Dow Corning Corporation. “With counterparty risk analysis, for example, most corporates used to give the agencies free rein to get on with their job, and would rely almost entirely on their outlooks and ratings for that. But now, at least for our own counterparty risk analysis, our reliance on the ratings agencies has gone down. They still play an important role, but we combine their information with a greater proportion of research we have conducted ourselves.”
He is not alone in highlighting this pre-crisis over-reliance of corporates on credit ratings. In June 2014 the International Organisation of Securities Commissions IOSCO said “the role of credit rating agencies has come under regulatory scrutiny, mainly as a result of the over-reliance of market participants, including investment managers and institutional investors, on CRA ratings in their assessments of both financial instruments and issuers in the run-up to the 2007-2008 financial crisis.” Were the agencies entirely to blame for the corporates that found themselves in hot water during the crisis?
Here it is important to distinguish between corporate credit ratings activity – which has largely performed well for the ratings agencies before, during, and after the crisis – and the mortgage-linked ratings which drew such high-profile censure after the fall of Lehman Brothers.
Indeed, the ratings agencies are quick to point out that there is a distinct segregation between their mortgage-related securities businesses and that of corporate credit ratings. “A fact that is sometimes lost is that the crisis was largely limited to one asset class – US subprime mortgages, which is a very small piece of our business,” says Mike Dunning, European Head of Corporates at Fitch Ratings. “Corporate ratings have held up very well since the financial crisis, as evidenced by the default and transition data and reports that we regularly publish.”
And while non-financial corporate credit ratings businesses were not implicated in the turmoil in 2007-2009, the agencies have nevertheless taken steps to refine and enhance transparency on this side of their activity post-crisis.
“Since the financial crisis we have taken a number of steps to improve the overall performance of the business. Our criteria function operates independently of our ratings practice, and analysts now rotate so they don’t spend an indefinite amount of time on a single account,” says Peter Kernan, Managing Director, Criteria Officer, Corporate Ratings EMEA at S&P. “We are now regulated, too.”
Regulation is one area in the credit ratings industry that has altered post-crisis, with legislators in Europe and the US putting measures in place aimed at governing the integrity and transparency of the rating process and sustaining confidence in the quality of ratings being produced.
The Securities and Exchange Commission (SEC) in the US put a first round of regulation for ratings agencies into effect in 2007; this was supplemented by the 2010 Dodd-Frank Act, and in August 2014 the SEC adopted further requirements for credit ratings agencies. In Europe, agencies are regulated by European Securities and Markets Authority (ESMA) legislation that came into force in 2010.
Chart 1: Comparison of Moody’s, S&P and Fitch credit ratings
||Upper medium grade
||Lower medium grade
||Non-investment grade speculative
Source: Moody’s, S&P and Fitch
Beyond the reputational aspect of the ratings agencies, another question a treasurer might ask when it comes to the ratings agencies is, given a large part of their research is based on published historical financial information, where and how exactly do they add value in the ratings process?
“As a cash manager, I don’t really care what happened yesterday when I’m looking at credit ratings, I want to know what’s likely to happen tomorrow or next month,” says Dow Corning’s Coon. “Analysing a company’s financials definitely holds a lot of weight in predicting future performance, but you need to add further analysis and judgement to get something that’s forward-looking.”
“Historical information is always helpful, but it is only ever a starting point in our analysis,” says William Coley, EMEA Corporate Finance Group Credit Officer at Moody’s. “If all ratings were made just on the basis of historical information, you could rate everything by computer. Our analysts provide the additional and important dimension of forward-looking analysis so our ratings have a degree of stability and predictive quality.” He adds that Moody’s recently introduced a forward-looking grid score to its corporate Credit Opinions that demonstrates how it expects different elements of a company’s credit profile to evolve over the next 12 to 18 months in an effort to provide further transparency over their rating rationale.
For corporates issuing debt, the treasury department is likely to have considerable interaction with the ratings agencies’ analysts. Here the Big Three have several pieces of advice for the treasurer:
Watch the sensitivities.
“The key area for treasurers to keep an eye on is the rating sensitivities. The treasurers who manage the credit relationship well are the ones who stay close to that process, who actively engage with the ratings agencies’ analysts to keep us informed, to understand themselves what, if anything, it is that’s causing us to be concerned,” advises Fitch’s Dunning.
Engage in constant dialogue.
“We are constantly engaged in dialogue with the companies and entities that use our corporate ratings,” says S&P’s Kernan. “Our strategic goal is to ensure our criteria is very well understood by all parties who use it, and our new criteria make it much easier for corporate treasurers to foresee potential future ratings changes.”
“In recent years we have seen that, rather than approaching us on a just-in-time basis, many treasurers from issuing companies now come to us early on in the process to use a range of our products, such as unpublished monitored loan ratings, to their advantage, and to establish a sound relationship with the analyst,” notes Coley of Moody’s. “Best practice is that ratings committee outcomes should never come as a complete surprise to the issuer.”
As mentioned earlier, the ratings agencies are taking steps to improve the transparency around their methodologies. But might these efforts not dilute the judgement element that goes into a rating, thereby diminishing their value to users? Some in the treasury community evidently see it that way.
For example, in 2013 S&P issued a request for comment to gauge the market’s reaction to proposed changes to its revised corporate ratings criteria. The revisions impacted non-financial companies, and included changes to S&P’s corporate methodology, ratios and adjustments, country risk, industry risk, group ratings methodology and ratings above the sovereign.
At the time, the ratings agency said the move was intended to improve the transparency and comparability of its ratings. Although the clarifications in the revised criteria were welcomed by some treasurers, others expressed their concern at what they perceived to be the over-formalisation of the new criteria; something they argued has reduced considerably the role of judgement in the corporate ratings process.
L’Association Française des Trésoriers d’Entreprise (AFTE), for instance, while describing the revisions as a “proactive approach to criteria evolution,” also went on to claim that the new methodology could lead to too mechanical an approach to credit ratings. “Rating must not become scoring,” said the AFTE in an open letter to S&P.
According to S&P’s Kernan, this is not the case at all. “We went to great lengths when designing our corporate criteria to make them transparent but also to continue to embed them within our analytical process judgement calls,” he says. “There are many areas where our analysts and credit committees are having to make judgement calls.”
For example, if a corporate has undergone what S&P describes as a ‘major transformational event’ such as an M&A or significant recapitalisation, S&P’s analysts now have the ability to change the time series used in a rating, giving a reduced weight – or in some cases no weight – to historical information.
“Strategically we will continue to embed this judgement element within the ratings process. We believe we add value in this respect as we have deep, global insight into corporates and their industries, and the ability to make judgement calls in our financial forecasting is clearly very important,” he adds.
Fitch’s Dunning agrees that this judgement factor is key to the ratings agencies’ service. “You have to balance the issue of being visible and adding value to the process, but retaining this element of judgement within credit analysis is absolutely critical,” he explains. “This is something we defend very strongly; this judgement call needs to stay with us as it’s part of the value that we add as an independent third party with an objective opinion.”
And for those who are unsatisfied with the Big Three’s corporate ratings, a new player has emerged to offer an alternative, at least in Europe.
Scope Ratings was established in 2011, with its corporate rating business starting up in 2012. It has since begun rating banks and structured finance products, too. Scope intends to offer a local knowledge advantage to Europeans over its US-based competitors of Fitch, Moody’s and S&P.
“We rate smaller and midcap companies – but we will also rate larger corporates in the near future,” Britta Holt, Executive Director of Scope’s Corporate Ratings franchise, tells Treasury Today. “Scope used to be a family-owned business, which has provided us with a natural understanding of smaller and mid-sized companies. Our ratings business is a good option for investors looking for an alternative to the Big Three, who are all headquartered in the US.”
So far Berlin-based Scope has rated corporates in Germany, Austria, Spain, France and the UK. “We only rate European corporates. Our criteria are broadly in line with those of the larger players. We provide forward-orientated analysis, focusing on cash flow generation capability,” adds Holt. “We don’t focus on the sheer size of a company alone in our analysis, but also on its positioning in the market – we concentrate on this aspect much more than the larger ratings agencies.”
However, despite the emergence of Scope, as well as regional players like China’s Dagong Global, the hegemony of the Big Three appears hard to displace: in 2012 they accounted for around 95% of credit ratings worldwide.
Ratings in the future
It is interesting to note that despite the adjustments being made around methodologies in recent years, the fundamentals of corporate credit ratings remain, for the most part, familiar.
“Over the past five to seven years we have seen mass volatility in the financial markets, but our corporate ratings methodologies have not fundamentally changed, and they should not fundamentally change in future,” says Fitch’s Dunning. “Companies will be impacted by weaker markets, lower growth, or deflation, but the way we assess them should remain broadly the same.”
Moody’s Coley agrees that the basics of corporate ratings should not change radically. “Our corporate methodologies are not subject to step change, but rather an evolution as they are typically updated on a three- to four-year basis. The methodologies we have in place for traditional industries such as mining, shipping, manufacturing and retail have been developed over decades so our sector-specific views are not likely to change overnight,” he says.
“However, we do adapt to emerging trends – we now have a pay-TV methodology, for instance – and I’m sure we will create new methodologies when and if required to capture new industries that may emerge.” So, while fundamental revision of the ratings process is unlikely, ongoing subtle, incremental changes are a possibility.
That could mean, for example, interactive ratings tools that allow companies to experiment with variables and get an on-the-spot estimate of how these could impact their credit rating. “We are working on a navigation tool that can sit on a banker’s or treasurer’s desktop and allow them to adjust certain financial and operational parameters in an interactive manner to see how these affect the way we rate them,” adds Fitch’s Dunning. “Technological advancements like this should help further inform discussion between analysts and users, making the ratings process as visible as possible. This is to everybody’s advantage.”
Treasurers who use corporate credit ratings would also like to see technological advancements in the way ratings information is delivered. “While some of the ratings agencies’ client-facing products are very slick, from a cash management perspective we want to reduce the number of URLs and portals we have to use to access the information necessary to do our job,” says Dow Corning’s Coon. “The next step would be to systematically feed the ratings information I need into the TMS I already have in place. That is a question for the future.”