The corporate's quest to find financial flexibility

In our latest Nordea On Your Mind report "The financial life jacket", Hemming Svensson talks to Marina Albo, head of Corporate Finance Group EMEA at Moody's, about the approach to corporate ratings following the financial crisis, and how Moody's coverage has trebled since then. She discusses what financial key ratios are most important for external ratings, how Moody's views long-term and short-term funding, what markets are more resilient against an economic downturn and corporates' attitudes in a low-interest environment. She explains why she worries about the light use of covenants today and how this trend leads to fewer defaults – but also less recovery in the event of a default.

Generally, have there been any major changes to how Moody's sees or measures creditworthiness today, compared with before the global financial crisis of 2008-09?

Marina: During the crisis, certain classes of US structured finance mortgage-backed securities did not perform as expected, but this was not the case across all asset classes and sectors.

Over the decade since the crisis, we have made a number of changes to provide greater transparency in how our ratings work and what they mean. Focusing specifically on my area of expertise in corporate ratings, we have around 50 sector methodologies that we use to judge the creditworthiness of companies.

While today's methodologies are similar to those used in previous years, ratings have generally migrated to lower levels today than before the crisis. However, the major trend shifts stem from changed funding decisions by corporates rather than an altered view on methodology on our part.

We also look at any differences between the rating implied by the methodology and the final rating, which takes into account our full analytical input. For example, within commodities (metals and mining, oil and gas) there was a larger deviation between our model outputs and the ratings that we gave to entities and bonds in the industry. As there should be room for analytical input on top of our more rigid models, we generally allow for a two-notch difference between the strict methodology and the final rating.

We re-evaluate our methodologies as needed, and in the case of commodities we chose to adjust it slightly. Improved models reflect our way of thinking better rather than shifts in our way of thinking causing methodological change.

Following the financial crisis, we may put more emphasis on certain factors. For example, I would say that we pay more attention to liquidity, even if this is something that has been important all along. As an example, in recent times we have seen banks shift in the way they support corporates through, for example, supply chain financing. This might be a good deal for the banks – short-term, asset-backed and core to company operations. When challenges arise, we notice that banks were quick to cut back on these types of working capital facilities that might not have been transparent at the outset – not reported as financial debt or even off-balance sheet. Thus, we are very keen to map out these kinds of structures that our issuers use.

Another trend shift since the financial crisis is the amount of subordinated debt taken on by corporates. Previously, a company might have, let's say, around 30% subordinated debt, which worked as a cushion for the potential loss for senior debtholders. The same company today might very well have all senior debt, thereby increasing the overall risk for senior bondholders. This does not change the rating of entities, per se, but has instead caused the rating of bonds to converge on the rating of the entity, where they previously were more dispersed due to differing seniority.

Is diversification of funding a factor in your rating for corporate issuers? How do you think large corporates should think about short-term and long-term capital market funding versus bank funding?

Marina: We never give advice to customers, but from an analytical perspective there are some considerations that can matter materially for corporates. First, diversification of funding is important for liquidity. As we look at debt maturity profiles and companies' ability to repay or service their debt from cash flows, diversification of funding plays a role. Second, we look at access to capital markets, or to markets in general. Concentration of funding could be an issue if a company only funds itself in one particular market. If that market were to close, the company might not have other means of financing itself. On the contrary, a company tapping into different debt markets will have an easier way of financing itself in such a scenario. Third, if diversification of funding can lead to a reduced cost of capital for the company, notably through a strengthened interest coverage ratio, this would also be positive.

Long-term funding should fund the permanent capital needs of a company while short-term debt should be used for working capital or spikes in capital needs, such as M&A or investment programmes. In our rating committees and in monitoring, we look at liquidity over the next 18 months. It is a strong negative signal to us if a company cannot fulfil its financial obligations for the upcoming 18 months, and such a company is very likely to go through a rating action.

Diversification of financing looks different between markets. In the US, bond financing might be some 80%, while in Europe bank and bond financing is about half each. In my view, there are structural explanations for this difference: Europe seems to have a more diversified bank market and increasing competition on loan pricing, thereby making European corporates more prone to use bank funding.

Which debt capital markets are in your view more resilient to a weaker market environment, and which are most vulnerable? US versus Europe? Local/Nordic versus Europe? Investment Grade versus high yield? Long versus short tenors? 

Marina: It is quite difficult to answer which market would be more resilient. However, there are some lessons that we have learned from the 2007-09 financial crisis. One such lesson is that the US market is more resilient than the European market. The US market was open again in a matter of months. In the US, there was a price to pay in these market environments; nonetheless, the market was open and rather liquid. Europe was a different story and was closed for much longer.

Investment Grade is definitely more liquid than high yield in a weaker market environment. The high-yield market in Europe was more or less shut for over two years during the financial crisis. The few high-yield refinancing transactions that occurred during this time were really painful for the issuers. It is impossible to say whether the same pattern would repeat itself in a potential future downturn, but it is fair to say that Investment Grade is the safer haven.

When it comes to the consideration of bank versus bonds, I believe it is a market-by-market case. Every country has a bank sector of differing health. During the crisis, Scandinavian banks were still very supportive of local businesses, perhaps because they were not as affected by the sub-prime collapse as were US banks, for example.

Which financial key ratios are typically most important for a Moody’s credit rating, and should be most important for corporate issuers to try to protect in a downturn? 

Marina: There are three key ratios that appear in almost all sector methodologies that we use. We measure the leverage ratio using gross debt-to-EBITDA and adjust for leases and pensions. We also look at repayment of debt, for which we use retained cash flow-to-net debt to get a picture of how long it would take to repay debt with internally generated cash flow. The third key ratio we look at is interest coverage – ie some earnings or cash flow measure in relation to interest payments. This captures the ability of a company to pay its interest bill and how much headroom it has for those payments.

On top of these three key ratios, we judge whether the company has the ability to fulfil its obligations for the following 18 months, as well as some sector-specific key ratios (such as loan-to-value for real estate and holding companies, debt-to-EBITDA less capex in telecoms, etc).

This is only one side of the analysis, though. Financial key ratios play a role in the financial profiling of a corporate, but we also look at what we call a business risk profile, which is where the more evident differences across sectors emerge. For example, in a restaurant methodology we would look at the number of outlets. For a pharma company, on the other hand, we will look at the pipeline of new drugs and maturity profile of current patents. Thus, entities with the same financial profile may get very different ratings owing to business matters such as size, revenue visibility and profitability, which give indications of an entity's ability to handle future headwinds.

Have you seen changes in corporate attitudes to external credit ratings compared with ten years ago? Is the need for a rating lower today? What difference do you think having a rating would make in a potentially tougher market environment at some point ahead?

Marina: Investors that I meet in my everyday work use ratings as an additional reference point and tool as they make investment decisions. Diversity of financing or financing options are generally positive in a tougher market environment. For example, European unrated markets stayed closed for much longer than rated markets.

Do you think large corporate issuers have grown accustomed to abundant and cheap bond and commercial paper funding, and think of it as the new normal? 

Marina: Prior to the financial crisis, we saw companies that over-leveraged themselves, with some of them reporting debt-to-EBITDA of ~6x and beyond. Today, we do not really see these levels so frequently anymore. However, it is clear that corporates in Europe are taking advantage of the low-interest environment. We run stress tests in our analyses where we simulate what would happen if the interest rate were to increase. Some companies measure debt capacity as their ability to pay their interest bill. They seem to be well funded when interest is very low, but under the loupe of a stress test it can actually be quite worrisome. 

Are you monitoring other trends in the market where corporate behaviour or financing options differ from, say, ten years ago?

Marina: Another worry we have in this environment is that there seem to be fewer covenants than before. Bank and bond markets are converging on "covenant-light" or even covenantless documentation, thus it is easier for companies to continue in a financially undisciplined way without clear repercussions from financers. This concerns us; it leads to fewer defaults but greater losses when defaults occur. Previously, covenant breaches would impose default to some degree, but recovery rates would be high.

I believe that companies like covenantless loans because of their flexibility, but this could lead to a sense of lacking financial discipline if flexibility is wrongly used. This could make things much worse in the event where things actually go wrong. There is no direct link between ratings and the use of covenants, except in those cases where covenants are actually breached or close to being breached, meaning the company risks default. We definitely look at covenants, and we have covenant experts, but it is a two-sided coin. On the one hand, there is more flexibility and headroom without covenants or with light covenants; on the other hand, there is arguably more discipline with well-developed covenants. When there is a lack of covenants, we can use the targets that companies have communicated to the market (such as leverage ratio, loan-to-value, etc). We hold them to their word and this gives us a sense of their financial discipline. A company that takes uncomfortable decisions, such as raising equity in order to keep its targets, sends a strong signal to us about the level of financial discipline, which is an important consideration in the ratings process.

What do you think large corporates could do – and should do – to be ready for any less supportive credit environment in the future?

Marina: We do not give advice to issuers. However, from a credit perspective, anything that helps the company to have visibility into its revenue and develop a flexible cost base, and is intrinsic to what a company does, would be positive.

In terms of financial levers, the cost base and capex are important factors that we look at. Capex can usually be cut off quickly. Usually around three-quarters of cash generated goes into capex. If a company has flexibility in capex, that is positive. For example, some companies managed to steer away from capital expenditure during the recent commodity crisis of 2015-16. However, this behaviour will be difficult for high-yield issuers, as they have less headroom in their operations. So, it all really comes down to liquidity, where beyond 18 months of cash-flow needs should be covered, and where flexibility in the cost base, capex and dividends is positive.