A downgrade of a company’s bonds by one of the major credit-rating agencies can be disastrous for a firm’s image; at the very least, it can mean higher costs for borrowing money. But a downgrade often also devastates the company’s shares, which is especially true of a downgrade from investment grade to ‘junk’ or non-investment grade status, as many institutional funds are allowed to hold only investment-grade paper.
However, by appealing directly to the investment community, a company can sometimes mitigate the damage. Some European companies have successfully rallied support against the mainly US-based rating agencies, by using anti-American sentiments in Europe to persuade politicians to call for constraints on them.
Of course, a direct appeal to the capital markets will only be effective if the company has a strong argument against the downgrade, based on business fundamentals. More recently, one of the most prominent examples of a company weathering such a downgrade was German steelmaker ThyssenKrupp.
In early 2003 Standard and Poor’s (S&P) put 20 European companies under review for a possible downgrade due to concerns about unfunded pension liabilities, which it said were debt-like in nature. S&P said it would announce any downgrades within a month – and within the week had cut Thyssen’s rating by two notches to junk status. Thyssen had approximately Ä7 bn ($8.9 bn) of actual debt and about Ä7 bn in unfunded pension liabilities, making it one of the most clear-cut examples of the dangers S&P was trying to highlight with its shift in methodology. Previously, pension liabilities were not treated as debt by any of the rating agencies.
Market puzzled
Many in the investment community were puzzled as to why S&P would make such a dramatic cut, even though nothing in ThyssenKrupp’s financial picture had deteriorated dramatically. Their confusion was exacerbated by the fact S&P did not publish details of its new methodology for some months after the downgrade.
Neither of the two other major rating agencies, Moody’s and Fitch, joined in the downgrade. Nevertheless, various institutional investors had no choice but to sell their bonds because many funds have guidelines prohibiting investment in junk bonds. The bonds sank 8 percent within days, a dramatic fall for the normally stable investment.
‘It’s harsh to drop from investment grade to non-investment grade when nothing has changed,’ says Robert Manning, fixed-income analyst for ABN Amro bank. ‘The [bond] market had sympathy for the position ThyssenKrupp found itself in, but the market could not completely ignore the rating. Many professional investors, even if they were relatively sympathetic, had to sell.’
Even more equity investors exited the share, which plunged more than 30 percent on the news. Of course, none of these events was happening in a vacuum; many shares in the broader market were reaching all-time lows. Pension liabilities were also a hot topic as equity values had plunged worldwide, so most pension plans based on equities were also looking decidedly unhealthy.
‘In 2000, downgrades began to have a tremendous impact on the equity market in Europe, starting first in the telecom sector,’ says Catherine Gerst, a partner at the financial communications firm Brunswick Group. ‘Prior to that time, few European equity investors made the link between the price of equity and the price of credit. But shareholders began to view themselves as the most subordinated of the company’s creditors.’
Until mid-2000 Gerst was head of Moody’s Paris office, having spent more than a decade as a credit analyst. In her new position at Brunswick, her role is to advise companies on their communication with the debt market. ‘What’s surprising is that it took so long for investors to make the connection,’ Gerst says.
Companies with investment-grade paper can typically take out unsecured loans, but once their debt is rated ‘junk’ they can get only secured loans. And the price of borrowing goes up as the risk for the lending bank is seen as increased.
Appealing the case
Not willing to take the decision lying down, Thyssen argued forcefully against the rating agency’s logic. It said S&P failed to understand Germany’s unique system for pensions and that the company’s financial position had improved significantly since it was given the initial investment-grade rating.
In a series of interviews and statements, Thyssen went on the attack against S&P’s rationale. It also enlisted the help of two other German companies whose pension liabilities had been similarly treated, Deutsche Post and Linde, an industrial gases company.
The trio commissioned a study by two German academics to review S&P’s methodology. The academics published a report describing the rating as being at odds with the German pension fund system. Some within the German government backed Thyssen’s line and called for more regulation of the agencies.
Later in the year, S&P was again in hot water in Germany, this time over its proposed rating of the soon-to-be denationalized German banks. The French finance ministry and the EU chimed in, calling for the agencies to be made more accountable. In a time when anti-American sentiment was rife, it was not difficult to find European politicians to champion the cause of homegrown companies fighting against the big, powerful American agencies.
But despite the political support, ThyssenKrupp’s strategy could have failed if investors had not sided with the firm. ‘It’s not a good idea to issue a press release if you have no counter-arguments,’ notes Gerst. ‘Many companies in Europe have reacted to downgrades, but their arguments have been without substance and have had no impact. ThyssenKrupp, however, had a good case. It convinced investors its financial situation had not deteriorated.’
S&P holds firm
S&P also stood its ground, though, reaffirming the rating later in the year. It shrugged off criticism of its methodology and rejected arguments that it didn’t understand German culture. ‘It’s not at all uncommon for rating downgrades to be controversial and for companies to criticize the decision when they are downgraded, but that has never impeded our mission of providing independent, objective views to our primary constituency – the investors,’ says Martin Winn, director of communications at S&P ‘We have to have a globally consistent benchmark. International investors expect that. Although we are owned by a US-domiciled company, S&P is very much an international agency. We’ve been operating in Europe for 20 years.’
S&P had the right and the responsibility to change its methodology when it saw a potential problem for investors, agrees Gerst. Although 20 years ago, when rating agencies first entered Europe, their staff and focus were very much US-oriented, Gerst says that is no longer the case.
But when it comes to bonds, the ultimate authority is the investor, who seemed to side with ThyssenKrupp. The company’s bonds, despite their ‘junk’ status, recovered almost all of the lost ground by year’s end and the shares gained almost 60 percent during the year. ‘Nobody cares about the S&P downgrade anymore,’ says asset manager Lex Werkheim of Amsterdam-based Eureffect. ‘The rebound in the bond shows investors believed what the company was saying. It’s tremendously important how the company communicates with investors.’
The episode illustrated the efficiency of the bond market as new investors stepped in to scoop up ThyssenKrupp’s bonds and shares. It also served to highlight the place rating agencies should ideally have in the market. ‘The rating agencies have always said their ratings are only opinions, not recommendations, and should be taken only as that,’ Gerst says.
Indeed, many within the rating agencies are uncomfortable with the weight given to their opinions. Regulators have elevated the status of these opinions by requiring, in some cases, that liabilities be rated by agencies. ‘The ThyssenKrupp example is very encouraging,’ Gerst notes. ‘If you have a good point, you can react to a downgrade and convince your investors in the bond and equity markets of your case. That is very healthy because it returns the ratings to their correct status as merely opinions.’
