When the financial problems at WorldCom and Enron came to light, both companies had been enjoying extremely respectable credit ratings from Standard & Poor’s, Moody’s Investors Service and Fitch Ratings, the three credit rating agencies officially recognized by the SEC at the time. Enron’s debt wasn’t downgraded to below investment grade until days before it filed for bankruptcy in December 2001.
No wonder the quality of credit ratings has been called into question. But those weren’t the only bad marks the rating agencies have been getting. IROs and investors are equally upset by the sudden and steep rating downgrades that sometimes hit without warning. On February 11, for instance, Moody’s downgraded El Paso’s debt rating five notches in a single day, taking it from high-yield credit to junk bond status. By February 12, El Paso’s stock price had hit an all-time low. Abrupt turnarounds like this make IROs monitor their debt ratings with trepidation, fearing a reappraisal that will badly rattle investors.
The credit rating agencies have been largely insulated from competition; the SEC has long authorized only three firms to place their official imprimaturs on a company’s debt. In February, however, the big three’s tight hold on credit ratings loosened somewhat, when the SEC granted official status to a fourth: Toronto-based Dominion Bond Rating Service. Egan-Jones Ratings Co and Lace Financial Corp have also applied to the SEC for NRSRO (nationally recognized statistical rating organization) status.
The SEC and Congress are now looking at whether the federally regulated credit rating system serves the best interests of investors. In January the SEC issued a report on the role and function of the credit rating agencies, which Congress requested as part of the Sarbanes-Oxley Act. In April Congress lambasted the SEC for not moving fast enough.
SEC spokesman John Nester says the January report was issued because many of the companies embroiled in the most serious corporate scandals maintained high credit ratings up until their very public demise.
Others make an even stronger case for reform. Lawrence White, professor of economics at New York University’s Stern School of Business, believes the SEC has in the past forced the markets to pay attention to the big three without considering another – and better – system for tracking credit risk. ‘The markets should take care of whatever it is that the credit rating agencies do,’ says White. ‘The consequences of what the SEC has done are extremely unfortunate, anti-competitive and anti-investor.’
The issue of whether the credit agencies are doing their job successfully assumes even greater importance in troubled financial times. Kevin Rigby, global head of the ratings advisory group for debt capital markets at Deutsche Bank in New York, notes, ‘In volatile markets, a downgrade is particularly serious because there’s been a flight to quality. While it’s true that many companies have been downgraded, investors are focused as much, if not more, on credit ratings than they were in the past.’
A downgrade can also have a devastating effect on a company’s ability to expand. ‘In the late 1990s, credit was a cheap commodity and companies with even low single-B ratings could access the markets,’ says Rigby. ‘Now each rating notch differential is becoming much more critical to market access and the pricing of the bonds.’
Glen Grabelsky, managing director of Fitch’s credit policy group, says ratings have gained more clout as the debt markets have steadily replaced banks as funding sources, and as investment houses have cut their in-house credit analysis. Thus, he maintains, a credit rating – sometimes described as the world’s shortest editorial on a company – matters more than ever.
Proactive communication
Last September, when Moody’s downgraded its rating on Peoples Energy’s debt, the company immediately issued a press release headlined, ‘Peoples Energy affirms strong financial position in light of Moody’s action.’ ‘We wanted to be proactive,’ explains Mary Ann Wall, IR manager. ‘We wanted to make the point that we were disappointed that they took that action, but we still felt that we had a strong balance sheet and good cash flow.’
Although Wall received calls from buy-side and sell-side analysts, she notes that Peoples’ stock price was unaffected. ‘Putting out a press release made sure there weren’t any question marks over what the company thought about the downgrade,’ she explains.
For many companies, a downgrade affects the stock price, so a shift in credit rating is something IROs must be ready to address. ‘There’s now a well-documented, empirical record that when Moody’s and S&P change their rating on a bond, the market reacts,’ says NYU’s White.
Principles of open communication apply to a ratings change just as they do to other corporate mishaps. Deutsche Bank’s Rigby applauds IROs who communicate honestly and forthrightly in the face of a debt downgrade: ‘Companies need to come out with the information that yes, we were downgraded, these were the key reasons why, and this is how we’re addressing them.’
A common mistake, says Rigby, is to try to gloss over the downgrade or dispute it too vigorously. ‘In certain cases, we see in investor relations press releases that companies completely disagree with the downgrade. Investors are savvy enough to understand there’s probably something behind the downgrade. The IRO should be more specific about how the company is going to address these issues.’
Of course, a company’s response must depend on the extent of the downgrade. For Peoples Energy, the downgrade was relatively minor and the company’s bonds were still well within the investment-grade parameters. For a company that falls into the junk bond category, a fuller response may be needed. If bonds dip below investment grade, Rigby advises winning credibility with investors as quickly as possible as ‘liquidity can dry up very rapidly.’
An evolving process
While major credit rating agencies have not altered their fundamental approach in light of Enron and other corporate scandals, they are fine-tuning their processes. Debra Perry, senior managing director in the finance group at Moody’s, says her firm is now placing more emphasis on cash flow and an assessment of the quality of financial reporting, as well as on a host of corporate governance issues ranging from board composition to executive compensation. ‘When we look at cases that have blown up, there were corporate governance abuses and then credit problems,’ she notes.
Clifford Griep, chief credit officer at S&P, says his firm also expanded its ratings focus in the past few years, including concentrating more on governance and accounting quality. Meanwhile, Fitch is tracking new and different sources of information, such as bond spreads and yields, market acceptance of debt, equity prices, insider sales, and short sales, says Grabelsky. In addition, Fitch is making sure corporate governance is being uniformly factored into the ratings equation for companies in all industries.
Given the importance of a company’s credit rating, many IROs are getting more actively involved in shaping the ratings process. At Deutsche Bank, Rigby helps companies prepare for presentations with the rating agencies. His job is to help clients defend, bolster, or protect their ratings. ‘We help them present their stories in an optimal way to the rating agencies,’ he explains.
Typically, the CFO and the treasury staff take the lead in meetings with credit rating agencies, but the IRO is often present. Indeed IR professionals can help supply some of the information that credit rating agencies are newly considering in their assessments.
Those dissatisfied with the current ratings system point out that Moody’s, S&P and Fitch are paid by the issuers, and that such payments could possibly taint the objectivity of the ratings. Deutsche Bank’s Rigby notes that issuers sometimes pay the major agencies a fee to ask how an acquisition or other major change might affect the company’s credit rating – another practice that leads to a perception of conflicts of interest.
As recent events have cast doubts on the SEC-sanctioned rating agencies, independent agencies deserve watching. Sean Egan, a managing director at Egan-Jones Ratings, believes it makes a big difference who pays the rating agency for its analysis; institutional investors, not issuers, pay Egan-Jones. That’s why, Egan maintains, his firm warned investors about WorldCom, Enron and Global Crossing, while the three major rating agencies didn’t.
Another complaint is that S&P and Moody’s have been Tweedle Dee and Tweedle Dum, issuing downgrades in lockstep. If the SEC does decide to recognize a larger pool of rating agencies than the current four, companies might soon receive a range of credit ratings, just as the investment worthiness of a company’s stock may be judged by a dozen or more brokerage houses.
Although a larger pool of ratings would almost certainly take some of the sting out of an S&P or Moody’s downgrade, IROs might not reap the benefits of this change for quite some time. ‘Competition is always good. It keeps people honest, it keeps them on their toes,’ says Rigby. ‘But it will take time for new rating agencies to build up credibility from an investor’s standpoint.’
