It is odd that a credit rating agency would relegate a country’s foreign currency status to a lowly Caa1 while simultaneously saying it may upgrade that country’s largest corporation. But that is exactly what Moody’s Investors Service has done. In July, the agency cut Argentina’s foreign currency rating because of a “significant increase in default risk.” At the same time, it announced it was considering raising the rating of YPF, the Argentine oil company, which has a B2 foreign currency debt rating.
This bizarre situation is the result of Moody’s decision in June to review sovereign ceilings for 38 borrowers, of which 28 are Latin American. Most of the 28 are banks, most of them Brazilian. They include credits like Banco Bradesco, Banco Itaú and Unibanco, the three largest locally-owned banks. Moody’s ratings of the governments’ foreign currency bonds have generally served as ceilings for ratings of foreign currency debt obligations of domestic issuers because they are subject to foreign currency transfer risk.
Moody’s new strategy is at odds with Standard&Poor’s, which argues that local banks especially should only be rated above the sovereign in exceptional circumstances. S&P’s view is that banks are more likely than companies to be affected by exchange controls and are more exposed to a general economic downturn. Banks are also likely to have larger holdings of government securities in both local and foreign currencies. S&P likewise regards government-owned entities as poor candidates for upgrade beyond the sovereign, a point on which it disagrees with Moody’s.
Moody’s aggressiveness on ratings became clear last year in Mexico when it promoted the country’s foreign currency rating to investment grade, four months ahead of the July presidential elections. This August, it signaled a possible upgrade when it changed its outlook on Mexico to positive from stable. S&P, though, has yet to raise Mexico to investment grade.
Some investors question the value of Moody’s change at a time of emerging markets crisis. As Peter Geraghty, managing director at Darby Overseas Investments in Washington says, “In the context of what is happening to the sovereigns, the corporate side of the equation does not have a lot of meaning.” He says what really matters is not currency ratings, but whether or not markets are open or shut.
Still, Geraghty says the widening division between strong and weak borrowers in Latin America means that Moody’s new policy could serve some purpose. “There is a handful of true multinationals in the region that gets tarred with the same brush as the sovereign,” he says. “For them it probably makes sense.”
Moody’s said in June it would rate borrowers above the country ceiling when they met three criteria: sound creditworthiness, including “external support mechanisms,” the probability that there would not be a generalized moratorium in the event of default by the government; and the borrower’s access to foreign exchange. This is why YPF, owned by Spain’s Repsol, escaped unscathed the collapse in ratings in Argentina.
Since June, Moody’s has raised the ratings of three Latin companies, all of them Mexican, above the sovereign ceiling. It rated Pemex, the state oil monopoly, as Baa2, one notch above the sovereign’s Baa3 investment grade. It awarded a Baa1 rating to Telmex, the private-sector phone company. The agency rated the foreign currency bonds of América Móvil, a cell phone company recently spun off by Telmex, as Baa2.
David Levey, managing director at Moody’s, says there have been changes in “capital market structures and in government behavior, particularly with regard to overall moratoriums, that need to be taken into account.” He argues that the recent experiences of Ecuador, Ukraine and Pakistan demonstrate that governments are now less likely to restrict foreign currency outflows in a default. However, none of these countries had companies with significant foreign debts, unlike Brazil or Argentina. Vincent Truglia, also a Moody’s managing director, argues that sovereign rating decisions include a political view on the willingness of governments to honor their debts and allow private-sector borrowers to do so as well.
S&P first addressed the issue of rating corporate debt issuers above their sovereign in 1997 when it first introduced the notion of dollarization criteria. S&P reasoned that the more dollarized an economy became, the less likely governments would be to introduce capital controls. Panama is the clearest example of this. However, most countries that have adopted the dollar are small, such as Ecuador, El Salvador and Panama. Fitch also began rating issuers above sovereign ceilings in 1997. Fitch Managing Director Daniel Kastholm says, “We have always said there are certain circumstances in which entities should be rated above the sovereign. Our policy has not changed over the years.”
Default or Transferability
In Argentina, Fitch believes there is a greater risk of sovereign default than there is a threat to transferability. This is why it differentiates between the country and sovereign ceiling ratings. Fitch’s sovereign rating for Argentina is B- and the country ceiling is two notches higher at B+. It rates 15 Argentine companies, such as YPF, Telefónica, the telecom group, and the TGS gas pipeline operator at the country ceiling. But Fitch grades all seven banks it covers in Argentina at the lower sovereign rating. Peter Shaw, Fitch bank analyst, says, “Bank ratings seldom go over the sovereign ceiling. What holds them back are their holdings of government securities.”
Moody’s approach is particularly controversial in Brazil. It is difficult to believe that Brasília would avoid imposing currency controls on its large state-owned companies in a crisis. Still, Moody’s is considering upgrading its ratings on Banco do Brasil, the country’s largest banking group, and Petrobras, the oil company that is also Brazil’s biggest company. Petrobras is an active issuer in the international capital markets, where it has raised $1.05 billion in bonds this year alone.
Some investors are buying the Moody’s argument. As Stephen Wilson-Smith, head of credit research at M&G Investment Management in London, points out, “Ratings should be done on a case-by-case basis. It’s not terribly misguided for the agencies to take another look at some companies that earn a lot of foreign currency and can keep it abroad and have bank lines abroad. It’s punitive to keep them at the sovereign ceiling.” Says Maurice Meijers, emerging markets fixed income fund manager with Robeco in the Netherlands, “I understand what the agencies are doing.
There are very good reasons why a corporate should be rated above a country ceiling. We look at the spread of assets and the source of the majority of the cash flow to arrive at an implied rating. We invest in corporates in Brazil and Argentina that have links to Spanish and US companies and we’re comfortable with that.”
S&P rates three companies in Mexico above the sovereign: Femsa, the local Coca-Cola bottler, Kimberly Clark’s Mexican affiliate and Cemex, the Mexican-owned multinational cement group. Laura Feinland-Katz, chief criteria officer for Latin America for S&P, says, “Cemex is only really half-Mexican with substantial assets in the US and Spain.” Assets are the principal issue from the agencies’ viewpoint, because it is hard for governments to seize a company’s overseas assets. S&P’s focus on assets means that it has only rated ever one Brazilian company above the sovereign. It had awarded Bunge Alimentos, then part of Argentina’s Bunge y Born international food group, a BB- rating before upgrading Brazil’s foreign currency rating to BB- in January. Feinland-Katz does not expect S&P to assign a corporate rating significantly higher than the sovereign in Brazil.
Investment grade status matters a lot because many investors are still constrained and guided by ratings, and ratings upgrades move markets. “Irrespective of valuation arguments, there are flow arguments in response to rating changes,” says Paul Murray John, head of emerging markets at Zurich Scudder. “There will be a weight of money that will mean these credits are better bid.” This means that agencies’ decisions to raise a company’s rating can spark a rally in its shares and debt.
Moody’s new approach to sovereign ceilings has put the spotlight on the question of how the agencies discharge such heavy responsibilities. Murray John says agencies are becoming more activist: “They are certainly becoming more aggressive and quicker to downgrade and upgrade.”
This is partly because the agencies slowly during the recent crises in emerging markets. Moody’s Levey says agencies now must “get ahead of trends [and] anticipate events, not follow them.” Likewise, S&P’s Feinland-Katz says, “We can’t take our business for granted. We need to be cutting-edge. That means being in tune with the market.”
Agencies and the Market
Paradoxically, the market is one of the agencies’ main competitors. Rapid information flows allow financial markets to react to news more quickly than the agencies and can crystallize the opinions of a multitude of participants. “In many ways the market is giving a quicker judgment than the rating agencies,” says Nicholas Field, asset manager for global emerging markets bonds at WestLB in London.
The agencies concede this. Their response is to retreat to the high ground of independence and the balanced view. “Markets have more volatility and prices bounce around,” says Levey. “The agencies have more of a medium-term and long-term focus on default risk, so there is not necessarily a correlation between markets and ratings.” He recalls that in 1994, prior to the peso crisis, Mexican spreads had narrowed to 80 basis points. Levey says this “was ridiculously tight. We didn’t move the rating and then the crisis hit Mexico. So we’re right sometimes and the markets are right sometimes.” An independent input is also valuable, says Feinland-Katz, because there is less research in emerging markets, less disclosure and less access to management.
Rating agency policies more accurately reflect the complexities of the marketplace, but they also introduce more qualitative judgment calls into the ratings process. That qualitative element is just one part of an overall reassessment of what the ratings agencies deliver. Realizing that there is a subjective element in what they do now is bringing agencies closer to other information providers: investors need to think more on their own. LF