Treasury Today Country Profiles in association with Citi

Time to get rated?

Bank cards laying ontop of a calculator

A credit rating can offer treasurers a means of accessing diversified sources of funding. Given the economic and geopolitical uncertainty that prevails in many parts of the world, perhaps it is time to consider the value of an independent assessment of your organisation’s creditworthiness. Treasury Today takes a back to basics look at what a credit rating really means.

There are many reasons why a credit rating may be desirable in the corporate sector. Every company needs to be prepared for future financial events, this being a key role for the treasurer. With a notable trend in the UK over the last few years, following the US example, for diversifying away from bank borrowing and instead heading towards capital market and private placement funding, a credit rating can become an integral part of an organisation’s future growth plans.

What is a credit rating?

A credit rating is a considered, forward-looking opinion offered by a professional independent credit rating agency (CRA) concerning the relative ability of the rated entity (such as a corporate or a bank) to meet its financial commitments.

The main distinction within the scope of a rating is between the public, the private and the confidential. A public rating is a highly visible means of articulating the entity’s credit story to a broad sweep of stakeholders, including investors and analysts, helping them to form more accurate assessments of any investment or lending decisions concerning that entity.

Ratings that are offered privately may be used to support an entity’s private funding exercise, in which it may be seeking to better articulate its own credit story to, for example, the private placement or direct investment market. A private rating story may also be told to select business counterparts, perhaps prior to a corporate establishing a significant new trading relationship or in the negotiation of new commercial terms.

The advantage of a private rating is that it enables the company to understand the way in which external parties view its credit status, how the agency rates it relative to its peers, and also to understand the key ratings drivers in terms of its ongoing ratings performance. It will then be the decision of the company – not the CRA – to choose when (and if) it wishes to make its rating public, sharing with a broad set of market counterparts.

It may be that a company wishes only to dip a tentative toe in the credit rating pool, in which case it may opt for a confidential rating, giving it time to internally digest the information. Confidential ratings may be used as part of an internal benchmarking exercise, where an entity requires a comparison with its publicly-rated competitors. This understanding can help it to develop its own business and commercial strategies.

The process of investigation to reach a rating decision is the same in all cases. The rated business can terminate its relationship with the CRA at any time.

Rating purpose

The main aim of a credit rating is to offer a transparent, consistent and independent assessment of an entity’s creditworthiness. This helps the accurate pricing of credit risk for that business.

An entity may call upon the opinions of more than one CRA, this decision largely depending upon factors such as purpose or geography.

Achieving a rating means the entity will have undergone a high level of disclosure and evaluation. For investors, ratings are commonly seen as a trusted benchmark when making investment decisions.

The principal benefit of a rating is therefore to give increased comfort to stakeholders that the holder, having undergone independent analysis, has been independently and soundly judged on the basis for which the rating has been applied. For the rated corporate, it can be a means of opening up a wider pool of investors or of securing improved debt pricing.

Once issued, a public credit rating will be continually monitored and assessed by the issuing CRA in terms of the entity’s performance. This provides stakeholders with as accurate, timely and consistent a picture of that entity’s relative creditworthiness as is possible.

Of course, it is up to each market constituent to decide to what extent it incorporates the rating into its decision-making. Each will call upon their own additional sources of data and information, including the more detailed ‘personal’ story of the target company.

CRAs

Moody, S&P and Fitch today represent the Big Three, issuing an estimated 95% of the world’s ratings. They are similar of purpose, but nuanced differences are observable. Each has its own rating scale although the scales do offer equivalency, so can be said to offer a different way of expressing the same view.

However, each also publishes its own rating criteria which means an offered rating can vary from one CRA to another, based on a view of the same entity. The three main CRAs do not all operate in the same markets and there may be some jurisdictions that one covers that the others do not.

There are almost 100 other credit rating agencies and organisations spread across more than 40 countries globally. All are smaller than the Big Three, some of these concern themselves only with domestic ratings, their relative merit being based on deep local market knowledge and, arguably, cost for the entity being rated. On the latter, CRA fees are typically charged for the initial rating and for the necessary ongoing surveillance of the entity’s performance.

The Big Three are more widely known but the choice of CRA might depend on a number of factors. These might include the size of the rated company, the location of its operating activities and its head office or group treasury, the volume of debt being sought, and locations in which it plans to tap the capital markets, use long-term bank funding or seek direct investment from institutional investors.

Ratings advisor

The rating process can be quite straightforward, especially for listed companies used to dealing with equity analysts, although the equity analyst’s focus is more on assessing share value than the CRA’s emphasis on creditworthiness.

However, many businesses seeking an initial rating, or those with challenging operating circumstances (such as a difficult jurisdiction or where liquidity is a perceived issue), do decide to use a ratings advisor to ensure their business is accurately represented and thus the rating fairly reflects the perceived risk.

Advisors will often be connected to the applicant’s lead bank, particularly where bond issuance is the goal, but could equally be a debt advisor in the relevant market. The advisor’s job is to steer its client through the process.

Credit ratings1

Moody’s Standard & Poors Fitch
Investment grade Strongest Aaa AAA AAA
Aa AA AA
A A A
Baa BBB BBB
Non-investment grade Weakest Ba BB BB
B B B
Caa CCC CCC
Ca CC CC
C C C
C D D
  1. These credit ratings are reflective of obligations with long-term maturities

Source: Reuters

Starting out

The key to success with an initial rating is effective information gathering. There are two broad corporate-specific (as opposed to general market) categories here.

Qualitative data will present factors such as industry risks, competitive position of the business, the state of corporate governance, management experience, anticipated transformative events (such as major M&A), product portfolio, geographical presence, operational scale and flexibility.

Quantitative data will also be sought, including numerical elements such as audited accounts, financial performance (cash flow, profitability and so on), financial position (including capital structure and level of gearing), and how financial risks such as funding and liquidity are managed.

There are two additional practical considerations for the corporate. The CRA will require a formal ratings presentation of the key facts and figures. This entails a detailed face-to-face Q&A session with senior management.

A decision must be taken early on as to who is best placed to meet the CRA to present the right picture. Usually this will involve the CEO, CFO, COO and the Group Treasurer. All personnel will need to be both available and fully briefed on the process. CRAs do not give advice so the presentation may be prepared in-house by the company or with the guidance of a ratings advisor.

The second point for consideration concerns the likely request by the CRA for confidential information from the corporate. A preparatory internal discussion on what can and cannot be disclosed is necessary to prevent the process from grinding to a halt but principally to help the CRA gain the most accurate impression of the business.

The corporate is not obliged to give any confidential information, but in the interest of gaining an accurate rating, the business should be prepared to be as transparent as possible.

Ultimately, a rating must be forward-looking, so history is never going to be the sole source of information. Forecast data will therefore be required. It is likely that, once all data has been aggregated, stress testing certain scenarios will help the CRA form its opinion.

Fair judgement

When rating a corporate, CRA analysts will source and sift a wide range of public and private qualitative and quantitative data.

The reality of deriving a credit rating is complex for the CRA not least because it must put its view into a very broad commercial context. By assigning a rating, the CRA is not just providing an opinion and a rationale about a company and its role in its operating sector but it is also necessarily comparing it objectively to all the other companies that it rates.

Using a common language to discuss credit quality thus means an individual rating from one CRA allows an investor to compare relative creditworthiness regardless of the class of debt it is applied to. Although not all CRAs will take the same view of that creditworthiness, well-known equivalency amongst their ratings make for easy comparison.

A to D of ratings

Issuers will normally be given a rating as a business. In addition, all its debt issuances can be rated. If, for some reason, the company does not agree with the rating decision it can appeal to the CRA if it provides materially new or additional information, but there is no specific right to do so.

Ratings range from investment grade (where, for example, S&P’s AAA is at the top, down to its BBB- at the bottom) to the non-investment or high-yield grade, which for S&P ranges from BB+ down to D (D being a state of default).

For all but defaulted ratings, or very low-rated issuers, where default risk is already very high in the ‘C’ to ‘CCC’ rating categories, the CRAs also offer a ‘rating outlook’ to guide investors on the likely direction of their rating over a one- or two-year period.

This dynamic assessment ranges between ‘positive’, ‘stable’ or ‘negative’. This comes with the option of placing the issuer on a shorter timeframe (three to six months) ‘rating watch’ where events dictate, again citing a negative or positive stance based on the expected outcome of a major event (such as an M&A).

A ratings watch can be applied to a business when something material is expected to change its credit profile; a debt-funded acquisition that might materially affect the leverage metrics, for example. A rated company will already have agreed ‘rating headroom’ at its existing rating level whereby it has a degree of latitude before it would become necessary to consider changing the rating.

Being junk

Most businesses will spend a long time considering the prospect of securing a rating. If they have used the services of a ratings advisor to help them consider their options, it may become apparent that the they will not receive the expected rating. Some may not pursue it any further but there is still value in undertaking the rating process, as an input to their strategic decision-making or as a snap-shot of current performance.

For companies that know from the outset that they are not at the higher end of the scale, or for those that are downgraded, even if they are moved into ‘junk’ territory (junk is predominantly an emotive investor term, CRAs prefer ‘high-yield’ or ‘non-investment grade’), CRAs will continue rating it all the while there is debt outstanding.

If the information required to maintain the rating is not available (such as if the company is in liquidation), the rating can be withdrawn by the CRA but generally, regardless of rating level, investors would want and need a rating on all outstanding debt; being able to provide it is beneficial.

Although a low rating may be seen as undesirable, the high-yield end of the investment spectrum it opens up for the holder still has an important role to play. An entity can elect to operate a capital structure that provides an optimal return for its shareholders. It could, for example, decide to operate as a highly leveraged company, possibly resulting in non-investment grade status. It is the company’s decision as to what capital structure it feels is appropriate for itself and for its shareholders but there is an investor base covering all ends of the ratings spectrum.

Managing the rating

A CRA will use multiple sources of information to regularly update its rating opinions. But between CRA and corporate, there is an expectation of good communication and flow of information. A sensible and reasonable level of transparency is therefore key to the success of the relationship. All ratings are subject to regular reviews by the CRA’s rating committee, to ensure its rating opinion stays current and is at least somewhat resilient to everyday market volatility.

This requires the identification and notification in advance by the corporate of any events that could influence the rating. The CRA should not be finding out about major events through media reports. Such events might include planned M&A or divestments, a new market or strategic direction, or a profits warning. A list of the company’s top ten exposures, or projections for the next two or five-year period, for example, may also be requested.

Volunteering information on transformative events (such as an acquisition) avoids the risk of the corporate being placed on review, possibly for a downgrade, giving the CRA time to formulate a full opinion on the significance of that event in terms of the corporate’s solvency position.

Where highly confidential information is called for, the corporate will already have made its decision on what it will reveal. But the CRA will only use that information to help inform its own opinion and prior to any public announcement (for a public rating), it will usually consult with the corporate to ensure that nothing contained therein will be to the detriment of the corporate and its stakeholders.

Value-adding exercise

Managing a rating is an ongoing process; for it to be useful for a wide range of stakeholders, the need is to keep it current at all times. To get the most out of the ratings process, it is advisable for the corporate not to see it as a test to be endured but instead to use it as an opportunity to add value to the business. Not only can a credit rating provide access to alternative funding sources but, in its assessment, the CRA will sometimes observe key strengths or greater risks within the organisation. Ideally, these impartial expert views should be used to make positive changes within.