Credit Ratings as an Investor Protection Mechanism? Anita
Goulding, Head of Rating Advisory, Asia 4 November 2005
Slide 2
CONTENTS Importance and Use of Credit Ratings Assigning Credit
Ratings Role of Rating Agencies Development of the Asian Bond
Markets Will Asias Bond Market emulate Australias Bond Market?
Corporate Hybrids
Slide 3
Importance and Use of Credit Ratings
Slide 4
What is a Credit Rating? A rating is an opinion on the future
ability and the legal obligation of an issuer to make timely
payments of principal and interest on a specific fixed income
security or other financial obligation Comparability/Transparency
Consistent, uniform and globally comparable grading system;
provides independent peer comparisons Measures the relative risk of
investing in a security (ie probability of default) There is a
strong correlation between short-term and long-term ratings.
Short-term ratings typically require back-up liquidity Supports
disclosure and transparency Forward-looking Expected to remaining
stable over 2 to 4 years Modified only for significant and
permanent changes in financial and/or operating performance
Slide 5
Major Uses of Credit Ratings Counterparty Ratings Bank Loan
Ratings Project Finance Listings Bond Issues Global and domestic
bond issues Straight and convertible bonds Ratings used to assist
IPO process Example is CNOOC Project finance ratings for toll roads
and IPP Power Projects General creditworthiness assessments Assists
with negotiations Bank loan ratings increasingly in demand
Slide 6
Benefits of a public credit rating Funding stability and
liquidity The international markets are very deep and liquid.
Highly rated companies can easily place debt that is 1 day to 30 or
more years in maturity The major capital markets have rarely been
closed for a highly rated corporate. Although price may be an
issue, access is not Diversified funding sources A rating enables
an issuer to access a broader range of funding sources other than
bank finance such as cross border investors in bonds, MTNs and
commercial paper A third party opinion expressed in terms of a
rating gives investors comfort over longer maturities Better
pricing A wider investor base is likely to create more competition
for a borrowers issue, driving down pricing to the cheapest level A
rating acts as a pricing guide to investors perhaps unfamiliar with
an issuers business and financial condition Wider investor base
Many US institutional investors and an increasing number of
European fund managers can: only buy paper that is rated allocate a
higher percentage of their portfolio to higher rated paper New BIS
rules will require banks to allocate capital based on ratings
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Wider access to the global capital markets Diversification of
investor base Means of communicating creditworthiness to key
counterparties Internal management tool to assist financial and
strategic planning Independent benchmark to help determine balance
considerations of bondholders and shareholders A Rating helps to
optimise funding Benefits of a Rating - Issuers
Slide 8
Benefits of a Rating - Investors Independent indicator of
credit quality Enhances transparency and disclosure Pricing
benchmark Facilitates secondary market liquidity Strategic tool for
portfolio management techniques Leading Institutional Investors
Rely on Ratings
Slide 9
Industry/Criteria knowledge (investigate new methodology, eg
JDA) Quantitative and qualitative approach Long term focus Client
Feedback Continuous monitoring Confidentiality Independent A
transparent rating process Why do Issuers and Investors Rely on
Ratings?
Slide 10
Additional Issues to Consider Should ratings be mandatory or
discretionary? poor financial disclosure of SMEs in Asia Rating
Compression and Investment Guidelines Development of secondary bond
market Solicited vs Unsolicited Ratings IOSCO Code of Conduct Use
of International Ratings (local and foreign currency) vs National
Ratings need to distinguish
Slide 11
Comparison of Thai Bank Ratings Moodys ratings on the top banks
in Thailand are at same rating as sovereign and could move up in
line with sovereign rating Moodys will soon revise its bank rating
methodology to better reflect bank default statistics. This could
result in a significant uplift for leading banks in the region and
narrow the gap between international ratings and local/national
ratings.
Slide 12
Assigning Credit Ratings
Slide 13
Management Management BusinessRisk influences determines
FinancialRisk Quantitative and qualitative approach Corporate
Ratings the Three Pillars
Slide 14
Rating Analysis Factors for Corporates Industry Characteristics
maturity cyclicality Diversification geographic product Competitive
Position market share technology efficiency Management credibility
experience strategies Financial Policy financial strategy risk
tolerance Profitability level and volatility trends of key measures
Cash Flow Protection Debt service capacity Capital Structure asset
quality leverage Financial Flexibility availability of internal and
external funds potential asset disposals Financial RiskBusiness
Risk
Slide 15
Corporate governance Concern over related party transactions
Group and accounting transparency Inter-group holdings,
transactions and guarantees Internal controls Risk management
regarding investments Liability management Sovereign ceiling not
only factor likely to hold back ratings
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RATING Band Performance Incorporating Expected Variations in
Performance Time Ratings Look Through the Economic Cycle
Slide 17
Ratings reflect priority or preference among obligations
(Contd) Issue Ratings Issue ratings also take into account the
recovery prospects associated with the specific debt being rated.
Junior debt (subordinated debt) is rated below the corporate credit
rating and preferred stock is rated still lower Well-secured debt
can be rated above the corporate credit rating
Slide 18
The case for Notching UP Key principles For investment grade
ratings, focus is on timeliness rather recovery Well-secured bank
loans or a first mortgage bond will be rated ONE notch above a
rating in the BBB or A rating categories but enhancement would be
TWO notches in the case of a BB or B corporate The following
guidelines relate more to the speculative grade portion of the
rating spectrum. At the upper end, notching is generally less
generous
Slide 19
The case for Notching DOWN Key principles Where priority claims
exist, lower-ranking obligations are at a disadvantage because a
smaller pool of assets will be available to satisfy remaining
claims Subordinated debt can be rated up to TWO notches BELOW a
non-investment grade corporate credit rating but ONE notch at most
if rating is investment grade Notching can arise if a company
conducts its operations through one or more legally separate
subsidiaries but issues debt at the holding company level (ie
structural subordination)
Slide 20
Role of Rating Agencies
Slide 21
Defaults by Rating after 1, 5, 10, and 15 years Cumulative
Average Default Rates 1981 to 2004 (%)
Slide 22
Defaults on Rated Debt
Slide 23
Capital Markets Corporate Issuers Corporate Issuers Regulators
Bank Trading Desks Institutional Investors Institutional Investors
Fixed Income Sales Force Fixed Income Sales Force Secondary trading
Market information New issue pricing Transaction feedback Market
information SEC Government Placement Structure feedback Rating
Agencies Portfolio monitoring Risk assessment Market information
Role of Ratings and Rating Agencies
Slide 24
#1 Credit ratings are for investor protection #2 A BBB rating
is investment grade #3 Harmonization of rating standards Rating
Myths
Slide 25
Non-rating requirements for Asian Bond Markets High accounting
and disclosure standards Fair and transparent capital markets
regulations and supervision A legal environment that instills
confidence among investors to participate in financial transactions
Efficient trading mechanisms and clearing/settlement systems that
are safe and low-cost
Slide 26
Development of the Asian Bond Markets
Slide 27
Excessive dependency on banking sector Underdeveloped domestic
capital markets Undisciplined foreign currency borrowings Lack of
adequate disclosure and transparency Inadequate risk management
practices Lessons from 1997 Asian Crisis
Slide 28
Source of Funds Use of Funds Depositors Borrowers Bank provides
liquidity Bank undertakes credit assessments Bank assumes credit
risk Bank Intermediated Bank Market
Slide 29
Source of Funds Use of Funds Investors Borrowers Market
provides liquidity Investors assume credit risk Credit rating
service provides measure of credit risk MARKET Disintermediated
Market
Slide 30
Provide local issuers with alternative sources of finance
Provide local investors with new investment opportunities Attract
foreign issuers Attract foreign investors Be an integral part of
the global financial markets Goals of Domestic Fixed Income
Markets
Slide 31
Relative Maturity of Asian Domestic Debt Markets Effective but
underused Hong Kong Singapore Effective but not efficient Korea
Malaysia Taiwan, China India Indonesia Philippines Thailand
Semi-effective or blocked Based on Transparency, Liquidity, Depth,
Role of Govt., # of active participants Hong Kong Institute for
Monetary Research
Slide 32
Asia Capital Markets Update FY 04 vs YTD 05 Issuance Volume by
Region Issuance Volume by CurrencyIssuance Volume by Tenor Source:
Bondware
Slide 33
Asia Capital Markets Update (Contd) # Deals by SizeIssuance
Volume by Rating FRN vs FXVolume by Industry Sector Source:
Bondware
Slide 34
Currency risk : who will bear Transparency and disclosure
Protection of creditor rights Ratings: Which standards and criteria
to adopt One pan Asian rating scale Rating compression Independence
and objectivity Affects competitive dynamics How will Pan Asian
rating agency be monitored Issues for Regional Bond Market
Slide 35
Will Asias Bond Market emulate Australias Bond Market?
Slide 36
Issuance volumes in the Australian domestic market have
experienced a fundamental change during the period 2000-2005.
Starting from annual issuance levels of approximately A$18-A$20bn
during the beginning of this period, issuance has surpassed A$40bn
during each of 2004 and 2005 ytd. Strong investor demand has
enabled primary market activity to consistently surpass volumes for
corresponding periods in previous years. This unprecedented volume
of issuance has been readily absorbed by the market as secondary
spreads remain at or near historic lows. Third quarter issuance of
nearly A$20bn has been a highlight of the year. Issuance in this
period was timed to correspond with the record A$8bn of corporate
redemptions matched to the 15 July 2005 Australian Government Bond.
Growth of the A$ market Issuance Summary Issuance levels have
increased from A$17.7bn in 2000, to A$45.5bn in 2005 ytd. Issuance
Volumes
Slide 37
The Australian corporate bond market has experienced dramatic
growth over the last 2 years. Following a period of relatively
stable issuance activity, issuance levels in 2004-2005 have been
more than double the 20002003 average. This growth has been driven
by a combination of factors. In March 2004 the Reserve Bank of
Australia extended the criteria for repo eligible issuers. A number
of Supranational and Agency borrowers such as Eurofima, KFW, LBBW
and Rentenbank were made repo eligible, significantly increasing
the attractiveness of these issuers to Australian investors. These
entities have now become among the most active issuers in the
Australian market, together with domestic banks. Issuers who are
rated AAA and have explicit or very strong government guarantees
can apply for eligibility. Drivers of growth in the A$ market
Regulatory Changes Regulatory Changes Rapid Growth 2000-05 Rapid
Growth 2000-05
Slide 38
Bond/swap spreads moved to historically wide levels in early
2004 and remain at similar levels. This means that sub-swap
product, for which there has traditionally been little demand, has
now became more attractive on a yield basis. Investors saw this as
an opportunity to move out of Government and Semi-government bonds.
In addition, the widening of the AUD/USD basis during this period
made A$ issuance more attractive to offshore borrowers. Kangaroo
issuance increased from 29% of domestic issuance in 2003 to 46% in
2004, and 47% for 2005 ytd. Drivers of growth in the A$ market
AUD/USD Basis Bond/Swap Spreads Supportive Technicals Supportive
Technicals
Slide 39
Issuance trends Issuance by Rating Issuance by Sector AA rated
borrowers make up a greater proportion of the market, driven by
large volume issuance from domestic and offshore AA banks such as
Wells Fargo, Citigroup and Bank of America. 2005200420032002 Banks
have consistently been the dominant borrowers in Australia.
Supranational and agency issuance has increased at the expense of
corporates.
Slide 40
The increasing sophistication of the domestic investor base has
made for improving issuance conditions in the Australian market. As
a result, a greater variety of issue types and structures are now
available to issuers. For example, an increasing proportion of
issuance is made up of long dated transactions: 23% of 2005 ytd
issuance is of a maturity of 8 or more years compared to 12% in
2001 and 10% in 2002. In addition, the domestic corporate hybrid
market has seen investors willing and able to invest in lower rated
instruments. Since December 2000, A$17.7bn of hybrid instruments
have been issued, nearly A$7bn of which has been unrated.
Consistently improving issuance conditions The increasing
sophistication of the Australian market means that a greater
variety of structures, tenors and volumes has become available to
issuers. Issuance conditions have become increasingly favourable
with issue spreads at or near historic lows. A$ Hybrid
Issuance
Slide 41
Issue spreads have contracted considerably over recent years. 5
yr domestic bank issuance is the best example, as there are a
number of such issues each year and the credit rating of the major
Australian banks have been stable over this time. Average issue
swap spread for an AA- rated 5 yr domestic issue has decreased from
around +20bps in 2002 to +15bps currently. Similarly, 5 yr A / A-
rated corporate issue spreads have also contracted markedly since
2000. Consistently improving issuance conditions (Contd) 5 yr Bank
Issue Spreads5 yr Corporate Issue Spreads
Slide 42
2005 Australian market highlights
Slide 43
2005 issuance characteristics Bank Issuance Dominates The
dominant sector of issuance has been the banking sector, with 30%
of YTD issuance coming from domestic banks, and 22% from offshore
banks and brokers. Supranational Taps Continue Supranational and
agency issuers combined make up 22% of domestic issuance. These
issuers have tended to access the market via A$100-200m taps to
existing issues when basis and bond/swap spreads are favourable.
Corporates Remain Relatively Absent Corporate issuance has been
light this year, however has grown to now be 9% of issuance. This
has been driven by three factors: Many Australian corporates
pre-funded much of their short term needs during the favourable
issuance conditions that prevailed during 2004. Corporates in
general hold large cash balances and have low Cap-Ex needs. A
number of Australian corporates have gone offshore to the Euro or
US Markets for tenor or volume. Strong Demand For FRNs Strong
demand for FRNs has been driven by investors concerned over the
pace of rate hikes earlier this year. FRN demand is more prominent
in transactions for 20% risk weighted borrowers. 2005 Issuance
Statistics
Slide 44
Demand for corporates remains strong Despite the unprecedented
large volume of issuance since July, demand for corporates in
particular remains buoyant for two reasons: A breakdown of bonds
maturing in July 2005 against those issued in the same month
reveals that investors replaced their higher yielding corporate
paper with a large volume of lower yielding financial supply. The
regular SMR DB Money Manager survey conducted fortnightly reveals
that investors are still holding high levels of cash on a
historical basis, despite the unprecedented level of issuance
during July September 2005. Corporate activity has been buoyant
recently with several issuers coming to market in September. Santos
(BBB+), Alinta (AAA wrapped) and Woolworths (A-) all issued during
the week of September 19 and were extremely well received by
investors. The tight levels achieved by these issuers of different
ratings and for different maturities highlight the demand for
corporate paper. July 2005 Redemptions vs IssuanceInvestors Cash
Holdings True corporate borrowers were relatively absent early in
the year, exacerbating the already present supply/demand imbalance.
Despite increased corporate issuance in Q3, demand for corporates
remains high amongst the large volume of bank supply.
Slide 45
Corporate Hybrids
Slide 46
Benefits of hybrid capital Hybrid capital combines features of
both debt and equity and accordingly, can provide issuers with
specific benefits of both debt and equity Hybrids are highly
flexible and may be tailored to achieve specific accounting, tax,
rating agency and legal outcomes and provide issuers with combined
benefits Hybrids provide benefits of debt Fixed, tax deductible
payments No dilution of earnings or voting rights No shareholder
approval required Repurchase flexibility (call rights) Equity
credit from rating agencies Improve balance sheet ratios Increase
debt capacity, covenant relief Deferral of payment obligations
without default Hybrids provide benefits of equity Non-dilutive
capital to fund growth / M&A that also provides ratings support
Opportunity to improve financial ratios (e.g. WACC & EPS) via
buyback Access to a new investor base Buy time with rating agencies
in need Positive signal to rating agencies Capital structure
flexibility
Slide 47
Hybrid capital inexpensive equity Issuers are now viewing
hybrid capital as a non-dilutive form of equity that is
significantly below the cost of equity Hybrid capital is widely
accepted as an equity substitute for up to 15% of an issuers
capital base An analysis of recently issued hybrids indicates that
hybrid capital is approximately 56% less expensive than issuing
equity on an after-tax basis see below
Slide 48
Recent hybrid transactions & issuance rationale Notching
from senior rating Rating Agency Credit Basket D 75% 50% Basket D
75% 60% Basket C 50% 50% Basket D 75% 50% n/a Basket C 50% 50%
Moody s S&P Moody s S&P Moody s S&P Moody s S&P
Moody s S&P Moody s S&P -2 -3 -2 -3-2 -3 n/a -2 Baa2 BBB-
Baa1 BBB-Baa3 BBB-Baa2 BBB n/a Baa3 BBB- Hybrid rating Highlights
First hybrid following rating agency developments 700m issued 1b
issued Book in excess of 2b 1.1b issued Book in excess of 3b
Largest hybrid to date 1.3b issued Book in excess of 5b Unrated
hybrid 150m issued Most recent hybrid offering 500m issued
Rationale for issuance Company under ratings pressure Both equity
and hybrid securities issued Hybrid equity credit improved capital
structure and cost of equity Unlisted & wholly owned by Swedish
government Issuer unable to access traditional equity capital
markets Hybrid provided significant equity credit and no dilution
of government stake Unlisted & wholly owned by Danish
government Issuer unable to access traditional equity capital
markets Hybrid provided significant equity credit and no dilution
of government stake Hybrid provided additional headroom for growth
within current ratings band Hybrid accessed additional equity
without dilution of existing shareholders Ratings support and
financial liquidity
Slide 49
Equity credit reflected in both balance sheet and income
statement All balance sheet (leverage) ratios are adjusted based on
equity credit designation Full interest / dividend (servicing cost)
ratios also adjusted based on equity credit designation Moodys
approach - overview An assessment of equity credit will focus on
the extent to which a hybrid contains three equity-like attributes:
Payment relief ability to omit payments, eliminate the potential
for payment default Permanence long term effective maturity Loss
absorption provides creditors a cushion in bankruptcy Primary
variables Equity credit designation Replacement language (vs non-
replacement) Mandatory deferral (vs. optional) Non-cumulative
payments (vs. cumulative) Basket A 100% debt Basket B 75% debt /
25% equity Basket D 25% debt / 75% equity Basket C 50% debt / 50%
equity Basket E 100% equity Moodys approach Basket D 3 out of 3
primary variables Basket C 2 out of 3 primary variables Basket B 1
out of 3 primary variables
Slide 50
Moodys approach required terms Optional discretionary Deferred
payments cash cumulative Mandatory trigger based deferral Mandatory
deferred payments non- cumulative on a cash basis (may be
cumulative where payable by equity funded ACSM) Optional
discretionary (cash cumulative) Deferral Minimum NC 5 Replacement
language not required Step-up maximum 100bps Minimum NC 5
Replacement language required for corporates Step-up maximum 100bps
Minimum NC 5 Replacement language required for corporates Step-up
maximum 100bps Call / Replacement Language Perpetual / 100+years
Perpetual / super long-dated (49+ years) Subordinated Maturity
Subordination Perpetual / 100+ years Preferred security or junior
subordinated Preferred security or junior subordinated with
covenant to remain most junior Optional discretionary Deferred
payments non-cumulative on a cash basis Cumulative payments that
are payable by equity funded ACSM acceptable Basket DBasket CBasket
B
Slide 51
Standard & Poors approach Standard & Poors has
simplified its approach to hybrids with equity content assigned on
the basis of 3 categories and formally adjusts financial ratios
reflective of the hybrid The majority of recently issued corporate
hybrids have achieved intermediate equity content The requirements
to achieve high equity content are restrictive including legally
binding replacement language and a tightly positioned trigger for
mandatory deferral Hybrids with high equity content will be treated
as equity for balance sheet and coverage ratios Hybrids with
minimal equity content will be treated as debt for balance sheet
and coverage ratios Hybrids with intermediate equity content will
be treated both ways - alternatively as debt and equity for both
balance sheet and coverage purposes (normally the analyst will then
split the difference) High Equity Content (71% - 100%) Intermediate
Equity Content (31% - 70%) Minimal Equity Content (0% - 30%)
Previous Scale New Scale Common equity Mandatory conversion pfd -
within 3 years 80% Mandatory conversion debt - within 3 years
Convertible pfd 50% 60% Conventional perpetual pfd - 5 year no call
Deferrable payment pfd (trust pfd) - 25+ years 40% Deferrable
payment debt - 25+ years 30% Convertible pfd -15+ years 20%
Deferrable payment debt - 10-15 years 0% Various pfd -15+ years 10%
70% 100% S&P equity content scale Intermediate equity content
key features Interest Deferral Requires no on-going payment that
could lead to default Nature of dividend stopper / pusher will be
considered Subordination S&P favours preference share
structures Where otherwise, hybrid must be economically equivalent
to a preference share Maturity No maturity or repayment requirement
Replacement language will provide S&P comfort Step-up limited
to 100 bps at year 10
Slide 52
Technical & commercial considerations Direct issue
structure Indirect issue structure Rating Agency considerations
Possible to structure Moodys Basket C or D / S&P intermediate
credit (via on-loan) (subject to jurisdiction where deduction
claimed and potential tension with accounting and rating agency
objectives) Tax deductibility Possible to structure as debt or
equity Accounting considerations (requires debt classification) FX
hedging
Slide 53
Accounting treatment Under IAS 32, hybrid securities are
classified as 100% equity or debt depending on the issuers level of
discretion over distributions and redemption Definition: a critical
feature in differentiating a financial liability from an equity
instrument is the existence of a contractual obligation of one
party to the financial instrument (the issuer) either to deliver
cash or another financial asset to the other party (the holder)
Structuring a debt classifed hybrid Direct issue structure Indirect
issue structure Hybrid structured as dated e.g. 100 years Hybrid
distributions treated as interest expense Hybrid structured as
dated e.g. 100 years Example: Bayer (100 year maturity) Hybrid
distributions treated as interest expense Structuring an equity
classifed hybrid Key requirement is to provide the issuer with
discretion regarding the timing of both distributions and
redemption Typical structural approach: Distributions are either
deferrable in perpetuity or non-cumulative; and Perpetual maturity
Hybrid distributions treated as dividends Key requirement is to
provide the issuer with discretion regarding the timing of both
distributions and redemption Typical structural approach:
Distributions are either deferrable in perpetuity or
non-cumulative; and Perpetual maturity Hybrid distributions treated
as dividends (on consolidation)
Slide 54
Hedge accounting Equity classified instruments however, are not
eligible to be a hedged item in a hedge accounting relationship
Foreign exchange risk can however qualify for hedge accounting if
the entity that issues the equity classified instrument on-lends
the proceeds via an inter-company loan to another group entity The
foreign exchange movements created between these entities (provided
they have different functional currencies) do not eliminate on
consolidation and may be hedged via a cross currency swap The
indirect structure achieves hedge accounting based on these
principles see discussion following page Achieving hedge accounting
for a debt classified instrument is relatively straightforward Debt
classified instruments are eligible to be a hedged item in a hedge
accounting relationship this allows an issuer to designate cash
flow hedges and fair value hedges where applicable Hedging debt
classifed hybrids Hedging equity classifed hybrids