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Published by Standard & Poor’s, a division of The McGraw-Hill Companies. Executive offices: 1221 Avenue of the Americas, New York, N.Y. 10020. Editorial offices: 55 Water Street, New York, NY 10041. ISSN 1097-1025. Subscriber services:(212) 438-2000. Copyright 2001 by The McGraw-Hill Companies. All rights reserved. Officers of The McGraw-Hill Companies: Joseph L. Dionne, Chairman and Chief Executive Officer; Harold W. McGraw, III, President and Chief OperatingOfficer; Kenneth M. Vittor, Senior Vice President and General Counsel; Frank Penglase, Senior Vice President, Treasury Operations. Information has been obtained by Corporate Ratings Criteria from sources believed to be reliable. However,because of the possibility of human or mechanical error by our sources, Corporate Ratings Criteria or others, Corporate Ratings Criteria does not guarantee the accuracy, adequacy, or completeness of any information and is not responsiblefor any errors or omissions or for the results obtained from the use of such information.

Dear Readers,This Internet version of Corporate Ratings

Criteria is updated and modified for changes incriteria as they occur. Similarly, statistics such askey ratio medians are brought up to date.

Standard & Poor’s criteria publications repre-sent our endeavor to convey the thought process-es and methodologies employed in determiningStandard & Poor’s ratings. They describe boththe quantitative and qualitative aspects of theanalysis. We believe that our rating product hasthe most value if users appreciate all that hasgone into producing the letter symbols.

Bear in mind, though, that a rating is, in theend, an opinion. The rating experience is as muchan art as it is a science.

Solomon B. SamsonChief Rating Officer, Corporate Ratings

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CORPORATERATINGS

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Contents

n STANDARD & POOR’S

INTRODUCTION

Standard & Poor’s Role in the Financial Markets 3Rating Definitions 7Rating Process 11

RATING METHODOLOGY

Industrials & Utilities 17The Global Perspective 30

Country Risk: Emerging Markets 34Sovereign Risk 37

Factoring Cyclicality into Corporate Ratings 41Regulation 44Loan Covenants 48

RATINGS AND RATIOS

Ratio Medians 53Key Industrial Financial Ratios 54Key Utility Financial Ratios 54Formulas for Key Ratios 55

Ratio Guidelines 56

RATING THE ISSUE

Distinguishing Issuers and Issues 61Junior Debt: Notching Down 63Well-Secured Debt: Notching Up 70

Bank Loan and Private Placement Rating Criteria 72“Tight” Covenants 78Airline and Railroad Equipment Debt 79Commercial Paper 81Preferred Stock 86

CRITERIA TOPICS

Equity Credit: What Is It and How Do You Get It? 91Equity Credit: Factoring Future Equity into Ratings 94A Hierarchy of Hybrid Securities 97

Parent/Subsidiary Rating Links 100Finance Subsidiaries’ Rating Link to Parent 104

Retiree Obligations: Pension and Medical Liabilities 107

Introduction

INTRODUCTION � Corporate Ratings Criteria 3

Standard & Poor’s traces its history back to1860. Today it is the leading credit rating orga-nization and a major publisher of financialinformation and research services on U.S. andforeign corporate and municipal debt obliga-tions. Standard & Poor’s was an independent,publicly owned corporation until 1966, whenall of its common stock was acquired byMcGraw-Hill Inc., a major publishing compa-ny. Standard & Poor’s Ratings Services is nowa business unit of McGraw-Hill. In matters ofcredit analysis and ratings, Standard & Poor’soperates entirely independently of McGraw-Hill. Standard & Poor’s Capital Markets,Funds Services, Investment Services, andResearch Services are the other units ofMcGraw-Hill’s financial services businesses.They provide investment, financial and tradinginformation, data, and analyses—including onequity securities—but operate separately fromthe ratings group.

Standard & Poor’s now rates more than $11trillion in bonds and other financial obliga-tions of obligors in more than 50 countries.Standard & Poor’s rates and monitors devel-opments pertaining to these issues and issuersfrom an office network based in 19 worldfinancial centers.

Despite the changing environment, Standard& Poor’s core values remain the same—to pro-vide high-quality, objective, value-added analyti-cal information to the world’s financial markets.

What is Standard & Poor’s?Standard & Poor’s is an organization of pro-

fessionals that provides analytical services andoperates under the basic principles of:

• Independence,• Objectivity,• Credibility, and• Disclosure.Standard & Poor’s operates with no govern-

ment mandate and is independent of anyinvestment banking firm, bank, or similarorganization.

Standard & Poor’s recognition as a ratingagency ultimately depends on investors’ will-ingness to accept its judgment. Standard &Poor’s believes it is important that all users ofits ratings understand how it arrives at the rat-ings, and it regularly publishes ratings defini-tions and detailed reports on ratings criteriaand methodology.

Credit ratingsStandard & Poor’s began rating the debt of

corporate and government issuers more than 75years ago. Since then, credit rating criteria andmethodology have grown in sophistication andhave kept pace with the introduction of newfinancial products. For example, Standard &Poor’s was the first major rating agency toassess the credit quality of, and assign credit rat-ings to, the claims-paying ability of insurancecompanies (1971), financial guarantees (1971),mortgage-backed bonds (1975), mutual funds(1983), and asset-backed securities (1985).

A credit rating is Standard & Poor’s opinionof the general creditworthiness of an obligor,or the creditworthiness of an obligor withrespect to a particular debt security or otherfinancial obligation, based on relevant risk fac-tors. A rating does not constitute a recommen-dation to purchase, sell, or hold a particularsecurity. In addition, a rating does not com-ment on the suitability of an investment for aparticular investor.

Standard & Poor’s credit ratings and sym-bols originally applied to debt securities. Asdescribed below, Standard & Poor’s has devel-oped credit ratings that may apply to anissuer’s general creditworthiness or to a specif-ic financial obligation. Standard & Poor’s hashistorically maintained separate and well-established rating scales for long-term andshort-term instruments. (A separate scale forpreferred stock was integrated with the debtscale in February 1999.)

Over the years, these credit ratings haveachieved wide investor acceptance as easily

Standard & Poor’s Role in the Financial Markets

� STANDARD & POOR’S

usable tools for differentiating credit quality,because a Standard & Poor’s credit rating isjudged by the market to be reliable and credible.

Long-term credit ratings are divided intoseveral categories ranging from ‘AAA’, reflect-ing the strongest credit quality, to ‘D’, reflect-ing the lowest. Long-term ratings from ‘AA’ to‘CCC’ may be modified by the addition of aplus or minus sign to show relative standingwithin the major rating categories.

A short-term credit rating is an assessmentof the credit quality of an issuer with respect toan instrument considered short term in the rel-evant market. Short-term ratings range from‘A-1’ for the highest-quality obligations to ‘D’for the lowest. The ‘A-1’ rating may also bemodified by a plus sign to distinguish thestrongest credits in that category.

Issue-specific credit ratingsA Standard & Poor’s issue credit rating is a

current opinion of the creditworthiness of anobligor with respect to a specific financialobligation, a specific class of financial obliga-tions, or a specific financial program. Thisopinion may reflect the creditworthiness of

guarantors, insurers or other forms of creditenhancement on the obligation and takes intoaccount statutory and regulatory preferences.

On a global basis, Standard & Poor’s issuecredit-rating criteria have long identified theadded country risk factors that give externaldebt a higher default probability than domes-tic obligations. In 1992, Standard & Poor’srevised its criteria to define external versusdomestic obligations by currency instead of bymarket of issuance. This led to the adoption ofthe local currency/foreign currency nomencla-tures for issue credit ratings. (See page 33.) Asrating coverage has now expanded to a grow-ing range of emerging-market countries, theanalysis of political, economic, and monetaryrisk factors are even more important.

In 1994, Standard & Poor’s initiated a sym-bol to be added to an issue credit rating whenthe instrument could have significant non-credit risk. The symbol ‘r’ is added to suchinstruments as mortgage interest-only strips,inverse floaters, and instruments that payprincipal at maturity based on a nonfixedsource, such as a currency or stock index. Thesymbol is intended to alert investors to non-

4 INTRODUCTION � Corporate Ratings Criteria


ISSUE-SPECIFIC CREDIT RATINGS

Long-term ratings• Notes, note programs, certificate of

deposit programs, syndicated bank loans,bonds and debentures (‘AA’, ‘AA’...‘D’); shelf registrations (preliminary)

Debt types:Equipment trust certificatesSecuredSenior unsecuredSubordinatedJunior subordinated

• Preferred stock and deferrable paymentdebt.

Municipal note ratings (tenor: less thanthree years) (‘SP-1+’, ‘SP-1’...‘SP-3’)

Short-term ratings (‘A-1+’, ‘A-1’...‘D’)• Commercial paper• Put bonds/demand bonds• Certificate of deposit programs

ISSUER CREDIT RATINGS

Long-term ratings and short-term ratings• Corporate credit ratings• Counterparty ratings• Sovereign credit ratings

OTHER RATING PRODUCTS

• Mutual Bond Fund Credit Quality Ratings(‘AAAf’...‘CCCf’)

• Money Market Fund Safety Ratings(‘AAAm’...‘BBBm’)

• Mutual Bond and Managed Fund RiskRatings (‘aaa’, ‘aa’,...‘ccc’)

• Financial strength ratings for insurancecompanies (also, pi ratings based on quantita-tive model)

• Ratings estimates• National scale credit ratings• Credit outsourcing• Rating evaluation service (RES)


credit risks and emphasizes that an issue cred-it rating addresses only the credit quality ofthe obligation.

Issuer credit ratingsIn response to a need for rating evaluations

on a company when there is no public debtoutstanding, Standard & Poor’s provides anissuer (also called counterparty) credit rating—an opinion of the obligor’s overall capacity tomeet its financial obligations. This opinionfocuses on the obligor’s capacity and willing-ness to meet its financial commitments as theycome due. The opinion is not specific to anyparticular financial obligation, as it does nottake into account the specific nature or provi-sions of any particular obligation. Issuer cred-it ratings do not take into account statutory orregulatory preferences, nor do they take intoaccount the creditworthiness of guarantors,insurers, or other forms of credit enhancementthat may pertain for a specific obligation.Counterparty ratings, corporate credit ratings,and sovereign credit ratings are all forms ofissuer credit ratings.

Since a corporate credit rating provides anoverall assessment of the creditworthiness of acompany, it is used for a variety of financialand commercial purposes, such as negotiatinglong-term leases or minimizing the need for aletter of credit for vendors.

If the credit rating is not assigned in con-junction with a rated public financing, thecompany can choose to make its rating publicor to keep it confidential.

Rating processStandard & Poor’s provides a rating only

when there is adequate information availableto form a credible opinion and only afterapplicable quantitative, qualitative, and legalanalyses are performed.

The analytical framework is divided intoseveral categories to ensure salient qualitativeand quantitative issues are considered. Forexample, with industrial companies the quali-tative categories are oriented to business analy-sis, such as the firm’s competitiveness withinits industry and the caliber of management; thequantitative categories relate to financialanalysis.

The rating process is not limited to an exam-ination of various financial measures. Properassessment of credit quality for an industrial

company includes a thorough review of busi-ness fundamentals, including industryprospects for growth and vulnerability to tech-nological change, labor unrest, or regulatoryactions. In the public finance sector, thisinvolves an evaluation of the basic underlyingeconomic strength of the public entity, as wellas the effectiveness of the governing process toaddress problems. In financial institutions, thereputation of the bank or company may havean impact on the future financial performanceand the ability of the institution to repay itsobligations.

Standard & Poor’s assembles a team of ana-lysts with appropriate expertise to review infor-mation pertinent to the rating. A lead analyst isresponsible for the conduct of the ratingprocess. Several of the members of the analyti-cal team meet with management of the organi-zation to review, in detail, key factors that havean impact on the rating, including operatingand financial plans and management policies.The meeting also helps analysts develop thequalitative assessment of management itself, animportant factor in the rating decision.

(An exception to these procedures is made inthe case of public information ratings. A pub-lic information credit rating is a local currencycredit rating identified by the “pi” subscriptand based on an analysis of the obligor’s pub-lished financial information, as well as addi-tional information in the public domain.Public Information ratings are not ordinarilymodified with “+” or “-” designations and arenot assigned outlooks. Ratings with a “pi”subscript are reviewed annually based on anew year’s financial statements, but may bereviewed on an interim basis if a major eventthat may affect an issuer’s credit qualityoccurs. At present, “pi” ratings are providedonly on Standard & Poor’s global scale.)

Following this review and discussion, a rat-ing committee meeting is convened. At themeeting, the committee discusses the lead ana-lyst’s recommendation and the pertinent factssupporting the rating. Finally, the committeevotes on the recommendation.

The issuer is subsequently notified of the rat-ing and the major considerations supporting it.A rating can be appealed prior to its publica-tion, if meaningful new or additional informa-tion is to be presented by the issuer. Obviously,there is no guarantee that any new informationwill alter the rating committee’s decision.


Once a final rating is assigned, it is dissemi-nated to the public through the news media,except for ratings where the company has pub-lication rights, such as traditional privateplacements. (Most 144A transactions areviewed as public deals.) In addition, in mostmarkets outside the U.S.—where ratings areassigned only on request—the company canchoose to make its rating public or to keep itconfidential. Confidential ratings are disclosedby Standard & Poor’s only to parties that aredesignated by the rated entity. After a publicrating is released to the media by Standard &Poor’s, it is published in CreditWeek or anoth-er Standard & Poor’s publication with therationale and other commentary.

Surveillance and reviewAll public ratings are monitored on an ongo-

ing basis, including review of new financial oreconomic developments. It is typical to sched-ule annual review meetings with management,even in the absence of the issuance of newobligations. Surveillance also enables analyststo stay abreast of current developments, dis-cuss potential problem areas, and be apprisedof any changes in the issuer’s plans.

As a result of the surveillance process, it issometimes necessary to change a rating. Whenthis occurs, the analyst undertakes a review,which may lead to a CreditWatch listing. Thisis followed by a comprehensive analysis,including, if warranted, a meeting with man-agement, and a presentation to the rating com-mittee. The rating committee evaluates the cir-cumstances, arrives at a rating decision, noti-fies the issuer, and entertains an appeal, if oneis made. After this process, the rating changeor affirmation is announced.

Issuers’ use of ratingsIt is commonplace for companies to struc-

ture financing transactions to reflect rating cri-teria so they qualify for higher ratings.However, the actual structuring of a givenissue is the function and responsibility of anissuer and its advisors. Standard & Poor’s willreact to a proposed financing, publish andinterpret its criteria for a type of issue, andoutline the rating implications for an issuer,

underwriter, bond counsel, or financial advi-sor, but it does not function as an investmentbanker or financial advisor. Adoption of sucha role ultimately would impair the objectivityand credibility that are vital to Standard &Poor’s continued performance as an indepen-dent rating agency.

Standard & Poor’s guidance is also soughton credit quality issues that might affect therating opinion. For example, companies solicitStandard & Poor’s view on hybrid preferredstock, the monetization of assets, or otherinnovative financing techniques before puttingthese into practice. Nor is it uncommon fordebt issuers to undertake specific and some-times significant actions for the sake of main-taining their ratings. For example, one largecompany faced a downgrade of its ‘A-1’ com-mercial paper rating because of growing com-ponent of short-term, floating-rate debt. Tokeep its rating, the company chose to restruc-ture its debt maturity schedule in a way con-sistent with Standard & Poor’s view of whatwas prudent.

(In 1998, Standard & Poor’s formalized itsratings advisory role under the name RatingEvaluation Service (RES). Standard & Poor’swill analyze the potential credit impact ofalternative strategic initiatives, establish adefinitive rating outcome for each, and sharethese with management. This service entails anengagement letter from the company withrespect to a specific plan or multiple plans.)

Many companies go one step further andincorporate specific rating objectives as corpo-rate goals. Indeed, possessing an ‘A’ rating, orat least an investment-grade rating, affordscompanies a measure of flexibility and isworthwhile as part of an overall financialstrategy. Beyond that, Standard & Poor’s doesnot encourage companies to manage them-selves with an eye toward a specific rating. Themore appropriate approach is to operate forthe good of the business as management sees itand to let the rating follow. Ironically, manag-ing for a very high rating can sometimes beinconsistent with the company’s ultimate bestinterests, if it means being overly conservativeand forgoing opportunities.




A Standard & Poor’s issue credit rating is acurrent opinion of the creditworthiness of anobligor with respect to a specific financialobligation, a specific class of financial obliga-tions, or a specific financial program (such asmedium-term note programs and commercialpaper programs.) It takes into considerationthe creditworthiness of guarantors, insurers, orother forms of credit enhancement on theobligation and takes into account the currencyin which the obligation is denominated. Theissue credit rating is not a recommendation topurchase, sell, or hold a financial obligation,inasmuch as it does not comment as to marketprice or suitability for a particular investor.

Issue credit ratings are based on informationfurnished by the obligors or obtained byStandard & Poor’s from other sources it con-siders reliable. Standard & Poor’s does notperform an audit in connection with any cred-it rating and may, on occasion, rely on unau-dited financial information. Credit ratings maybe changed, suspended, or withdrawn as aresult of changes in, or unavailability of, suchinformation.

Issue credit ratings can be either long term orshort term. Short-term ratings are assigned tothose obligations considered short term in therelevant market. In the U.S., for example, thatmeans obligations with an original maturity ofno more than 365 days—including commercialpaper. Short-term ratings are also used to indi-cate the creditworthiness of an obligor withrespect to put features on long-term obliga-tions. The result is a dual rating, in which theshort-term rating addresses the put feature inaddition to the usual long-term rating.

Medium-term notes are assigned long-termratings. Medium-term notes’ ratings, untilrecently, pertained to the program extablishedto sell these notes. There was no review ofindividual notes, and, accordingly, the ratingdid not apply to specific notes (with certainexceptions). As of spring 2000, Standard andPoor’s routinely assigns ratings to individual

drawdowns with a value of $25 million orabove.

Issue and issuer credit ratings use the identi-cal symbols. The definitions closely corre-spond to each other, since the issue rating def-initions are expressed in terms of default risk,which refers to likelihood of payment—thecapacity and willingness of the obligor to meetits financial commitment on an obligation inaccordance with the terms of the obligation.However, issue credit ratings also take intoaccount the protection afforded by, and rela-tive position of, the obligation in the event ofbankruptcy, reorganization, or other arrange-ment under the laws of bankruptcy and otherlaws affecting creditors’ rights.

Junior obligations are typically rated lowerthan the issuer credit rating, to reflect thelower priority in bankruptcy, as noted above.(Such differentiation applies when an entityhas both senior and subordinated obligations,secured and unsecured obligations, operatingcompany and holding company obligations, orpreferred stock.) Debt that provides excellentprospects for ultimate recovery (such assecured debt) is often rated higher than theissuer credit rating. (See pages 59-85.)Accordingly, in the cases of junior debt andsecured debt, the rating may not conformexactly with the category definition.

Long-term credit ratings‘AAA’ An obligation rated ‘AAA’ has the

highest rating assigned by Standard & Poor’s.The obligor’s capacity to meet its financialcommitment on the obligation is extremelystrong.

‘AA’ An obligation rated ‘AA’ differs fromthe highest rated obligations only to a smalldegree. The obligor’s capacity to meet itsfinancial commitment on the obligation is verystrong.

‘A’ An obligation rated ‘A’ is somewhatmore susceptible to the adverse effects ofchanges in circumstances and economic condi-

Rating Definitions


tions than obligations in higher rated cate-gories. However, the obligor’s capacity to meetits financial commitment on the obligation isstill strong.

‘BBB’ An obligation rated ‘BBB’ exhibitsadequate protection parameters. However,adverse economic conditions or changing cir-cumstances are more likely to lead to a weak-ened capacity of the obligor to meet its finan-cial commitment on the obligation.

Obligations rated ‘BB’, ‘B’, ‘CCC’, ‘CC’, and‘C’ are regarded as having significant specula-tive characteristics. ‘BB’ indicates the leastdegree of speculation and ‘C’ the highest.While such obligations will likely have somequality and protective characteristics, thesemay be outweighed by large uncertainties ormajor exposures to adverse conditions.

‘BB’ An obligation rated ‘BB’ is less vulnera-ble to nonpayment than other speculativeissues. However, it faces major ongoing uncer-tainties or exposure to adverse business, finan-cial, or economic conditions that could lead tothe obligor’s inadequate capacity to meet itsfinancial commitment on the obligation.

‘B’ An obligation rated ‘B’ is more vulnera-ble to nonpayment than obligations rated ‘BB’,but the obligor currently has the capacity tomeet its financial commitment on the obliga-tion. Adverse business, financial, or economicconditions will likely impair the obligor’scapacity or willingness to meet its financialcommitment on the obligation.

‘CCC’ An obligation rated ‘CCC’ is current-ly vulnerable to nonpayment, and is dependentupon favorable business, financial, and eco-nomic conditions for the obligor to meet itsfinancial commitment on the obligation. In theevent of adverse business, financial, or eco-nomic conditions, the obligor is not likely tohave the capacity to meet its financial commit-ment on the obligation.

‘CC’ An obligation rated ‘CC’ is currentlyhighly vulnerable to nonpayment.

‘C’ The ‘C’ rating may be used to cover a sit-uation where a bankruptcy petition has beenfiled or similar action has been taken but pay-ments on this obligation are being continued.‘C’ is also used for a preferred stock that is inarrears (as well as for junior debt of issuersrated ‘CCC-’ and ‘CC’).

‘D’ The ‘D’ rating, unlike other ratings, isnot prospective; rather, it is used only where a

default has actually occurred—and not wherea default is only expected. Standard & Poor’schanges ratings to ‘D’:

• On the day an interest and/or principalpayment is due and is not paid. An excep-tion is made if there is a grace period andStandard & Poor’s believes that a paymentwill be made, in which case the rating can bemaintained;• Upon voluntary bankruptcy filing or simi-lar action. An exception is made if Standard& Poor’s expects that debt service paymentswill continue to be made on a specific issue.In the absence of a payment default or bank-ruptcy filing, a technical default (i.e.,covenant violation) is not sufficient forassigning a ‘D’ rating;• Upon the completion of a tender orexchange offer, whereby some or all of anissue is either repurchased for an amount ofcash or replaced by other securities having atotal value that is clearly less than par;• In the case of preferred stock or deferrablepayment securities, upon nonpayment of thedividend or deferral of the interest payment.With respect to issuer credit ratings (that is,

corporate credit ratings, counterparty ratings,and sovereign ratings), failure to pay a financialobligation—rated or unrated—leads to a ratingof either ‘D’ or ‘SD’. In the ordinary case, anissuer’s distress leads to general default, and therating is ‘D’. ‘SD’ is assigned when an issuercan be expected to default selectively, that is,continue to pay certain issues or classes ofobligations while not paying others. In the cor-porate context, selective default might applywhen a company conducts a coercive exchangewith respect to one or some issues, whileintending to honor its obligations with regardto other issues. (In fact, it is not unusual for acompany to launch such an offer precisely withsuch a strategy—to restructure part of its debtin order to keep the company solvent.)

Nonpayment of a financial obligation sub-ject to a bona fide commercial dispute or amissed preferred stock dividend does not causethe issuer credit rating to be changed.

Plus (+) or minus(-): The ratings from ‘AA’to ‘CCC’ may be modified by the addition of aplus or minus sign to show relative standingwithin the major rating categories.

r Use of the “r” was largely discontinued asof July 2000.




Short-term credit ratings‘A-1’ A short-term obligation rated ‘A-1’ is

rated in the highest category by Standard &Poor’s. The obligor’s capacity to meet its finan-cial commitment on the obligation is strong.Within this category, certain obligations aredesignated with a plus sign (+). This indicatesthat the obligor’s capacity to meet its financialcommitment on these obligations is extremelystrong.

‘A-2’ A short-term obligation rated ‘A-2’ issomewhat more susceptible to the adverseeffects of changes in circumstances and eco-nomic conditions than obligations in higherrating categories. However, the obligor’scapacity to meet its financial commitment onthe obligation is satisfactory.

‘A-3’ A short-term obligation rated ‘A-3’exhibits adequate protection parameters.However, adverse economic conditions orchanging circumstances are more likely to leadto a weakened capacity of the obligor to meetits financial commitment on the obligation.

‘B’ A short-term obligation rated ‘B’ isregarded as having significant speculativecharacteristics. The obligor currently has thecapacity to meet its financial commitment onthe obligation; however, it faces major ongoinguncertainties that could lead to the obligor’sinadequate capacity to meet its financial com-mitment on the obligation.

‘C’ A short-term obligation rated ‘C’ is cur-rently vulnerable to nonpayment and is depen-dent upon favorable business, financial, andeconomic conditions for the obligor to meet itsfinancial commitment on the obligation.

‘D’ See definition of ‘D’ under Long-termRatings.

Investment and speculative gradesThe term “investment grade” was originally

used by various regulatory bodies to connoteobligations eligible for investment by institu-tions such as banks, insurance companies, andsavings and loan associations. Over time, thisterm gained widespread usage throughout theinvestment community. Issues rated in the fourhighest categories, ‘AAA’, ‘AA’, ‘A’, ‘BBB’, gen-erally are recognized as being investmentgrade. Debt rated ‘BB’ or below generally isreferred to as speculative grade. The term“junk bond” is merely a more irreverentexpression for this category of more risky debt.Neither term indicates which securitiesStandard & Poor’s deems worthy of invest-

ment, as an investor with a particular risk pref-erence may appropriately invest in securitiesthat are not investment grade.

Ratings continue as a factor in many regula-tions, both in the U.S. and abroad, notably inJapan. For example, the Securities andExchange Commission (SEC) requires invest-ment-grade status in order to register debt onForm-3, which, in turn, is one way to offerdebt via a Rule 415 shelf registration. TheFederal Reserve Board allows members of theFederal Reserve System to invest in securitiesrated in the four highest categories, just as theFederal Home Loan Bank System permits fed-erally chartered savings and loan associationsto invest in corporate debt with those ratings,and the Department of Labor allows pensionfunds to invest in commercial paper rated inone of the three highest categories. In similarfashion, California regulates investments ofmunicipalities and county treasurers; Illinoislimits collateral acceptable for public deposits;and Vermont restricts investments of insurersand banks. The New York and PhiladelphiaStock exchanges fix margin requirements formortgage securities depending on their ratings,and the securities haircut for commercialpaper, debt securities, and preferred stock thatdetermines net capital requirements is also afunction of the ratings assigned.

In some countries, investment regulationwill refer to ratings on a national scale.(Standard & Poor’s produces national scaleratings in several countries, including Mexico,Brazil, and Argentina.) These ratings areexpressed with the traditional letter symbols,but the ratings definitions do not conform tothose employed for the global scale. The ratingdefinitions of each national scale and its corre-lation to global scale ratings are unique, sothere is no basis for comparability acrossnational scales.

CreditWatch and rating outlooksA Standard & Poor’s rating evaluates default

risk over the life of a debt issue, incorporatingan assessment of all future events to the extentthey are known or can be anticipated. ButStandard & Poor’s also recognizes the poten-tial for future performance to differ from ini-tial expectations. Rating outlooks andCreditWatch listings address this possibility byfocusing on the scenarios that could result in arating change.


Ratings appear on CreditWatch when anevent or deviation from an expected trend hasoccurred or is expected and additional infor-mation is necessary to take a rating action. Forexample, an issue is placed under such specialsurveillance as the result of mergers, recapital-izations, regulatory actions, or unanticipatedoperating developments. Such rating reviewsnormally are completed within 90 days, unlessthe outcome of a specific event is pending.

A listing does not mean a rating change isinevitable. However, in some cases, it is certainthat a rating change will occur and only themagnitude of the change is unclear. In thoseinstances—and generally wherever possible—the range of alternative ratings that couldresult is shown.

Rating changes can also occur without theissues appearing beforehand on CreditWatch.An issuer cannot automatically appeal aCreditWatch listing, but analysts are sensitiveto issuer concerns and the fairness of theprocess.

A rating outlook is assigned to all long-termdebt issues—except for structured finance—and also assesses potential for change.Outlooks have a longer time frame thanCreditWatch listings and incorporate trends orrisks with less certain implications for creditquality. An outlook is not necessarily a precur-sor of a rating change or a CreditWatch listing.

CreditWatch designations and outlooks maybe “positive,” which indicates a rating may beraised, or “negative,” which indicates a ratingmay be lowered. “Developing” is used forthose unusual situations in which future eventsare so unclear that the rating potentially maybe raised or lowered. “Stable” is the outlookassigned when ratings are not likely to bechanged, but it should not be confused withexpected stability of the company’s financialperformance.




Most corporations approach Standard &Poor’s to request a rating prior to sale or regis-tration of a debt issue. That way, first-timeissuers can receive an indication of what ratingto expect. Issuers with rated debt outstandingalso want to know in advance the impact ontheir ratings of the company’s issuing addition-al debt. (In any event, as a matter of policy, inthe U. S., Standard & Poor’s assigns and pub-lishes ratings for all public corporate debtissues over $50 million—with or without arequest from the issuer. Public transactions arethose that are registered with the SEC, thosewith future registration rights, and other 144Adeals that have broad distribution.)

In all instances, Standard & Poor’s analyti-cal staff will contact the issuer to elicit itscooperation. The analysts with the greatest rel-evant industry expertise are assigned to evalu-ate the credit and commence surveillance ofthe company. Standard & Poor’s analysts con-centrate on one or two industries, covering theentire spectrum of credits within those indus-tries. (Such specialization allows accumulationof expertise and competitive information bet-ter than if junk-bond issuers were followedseparately from high-grade issuers.) While oneindustry analyst takes the lead in following agiven issuer and typically handles day-to-daycontact, a team of experienced analysts isalways assigned to the rating relationship witheach issuer.

Meeting with managementA meeting with corporate management is an

integral part of Standard & Poor’s ratingprocess. The purpose of such a meeting is toreview in detail the company’s key operatingand financial plans, management policies, andother credit factors that have an impact on therating. Management meetings are critical inhelping to reach a balanced assessment of acompany’s circumstances and prospects.

Participation. The company typically is rep-resented by its chief financial officer. The chief

executive officer usually participates whenstrategic issues are reviewed (which is usuallythe case at the initial rating assignment).Operating executives often present detailedinformation regarding business segments.

Outside advisors may be helpful in prepar-ing an effective presentation. Their use is nei-ther encouraged nor discouraged by Standard& Poor’s: it is entirely up to managementwhether advisors assist in the preparation formeetings and whether they attend themeetings.

Scheduling. Management meetings are usu-ally scheduled at least several weeks inadvance, to assure mutual availability of theappropriate participants and to allow ade-quate preparation time for the Standard &Poor’s analysts. In addition, if a rating is beingsought for a pending issuance, it is to theissuer’s advantage to allow about three weeksfollowing a meeting for Standard & Poor’s tocomplete its review process. More time may beneeded in certain cases, for example, if exten-sive review of documentation is necessary.However, where special circumstances existand a quick turnaround is needed, Standard &Poor’s will endeavor to meet the requirementsof the marketplace.

Facility tours. Touring major facilities can bevery helpful for Standard & Poor’s in gainingan understanding of a company’s business.However, this is generally not critical. Giventhe time constraints that typically arise in theinitial rating exercise, arranging facility toursmay not be feasible. As discussed below, suchtours may well be a useful part of the subse-quent surveillance process.

Preparing for meetings. Corporate manage-ment should feel free to contact its designatedStandard & Poor’s analyst for guidance inadvance of the meeting regarding the particularareas that will be emphasized in the analyticprocess. Published ratings criteria, as well asindustry commentary and articles on peer com-panies from CreditWeek, may also be helpful to

Rating Process


management in appreciating the analytic per-spective. However, Standard & Poor’s prefersnot to provide detailed, written lists of ques-tions, since these tend to constrain spontaneityand artificially limit the scope of the meeting.

Well in advance of the meeting, the compa-ny should submit background materials (ideal-ly, several sets), including:

• five years of audited annual financial state-ments;• the last several interim financial statements;• narrative descriptions of operations and prod-ucts; and• if available, a draft registration statementor offering memorandum, or equivalent.Apart from company-specific material, rele-

vant industry information may also be useful.While not mandatory, written presentations

by management often provide a valuableframework for the discussion. Such presenta-tions typically mirror the format of the meet-ing discussion, as outlined below. Where awritten presentation is prepared, it is particu-larly useful for Standard & Poor’s analyticalteam to be afforded the opportunity to reviewit in advance of the meeting.

There is no need to try to anticipate all ques-tions that might arise. If additional informa-tion is necessary to clarify specific points, itcan be provided subsequent to the meeting. Inany case, Standard & Poor’s analysts generallywill have follow-up questions that arise as theinformation covered at the management meet-ing is further analyzed.

Confidentiality. A substantial portion of theinformation set forth in company presentationsis highly sensitive and is provided by the issuerto Standard & Poor’s solely for the purpose ofarriving at ratings. Such information is keptstrictly confidential by the ratings group. Even ifthe assigned rating is subsequently made public,any rationales or other information thatStandard & Poor’s publishes about the compa-ny will refer only to publicly available corporate

information. It is not to be used for any otherpurpose, nor by any third party, including otherStandard & Poor’s units. Standard & Poor’smaintains a “Chinese Wall” between its ratingactivities and its equity information services.

Conduct of meeting. The following is anoutline of the topics that Standard & Poor’stypically expects issuers to address in a man-agement meeting:

• the industry environment and prospects;• an overview of major business segments,including operating statistics and compar-isons with competitors and industry norms;• management’s financial polices and finan-cial performance goals;• distinctive accounting practices;• management’s projections, including incomeand cash flow statements and balance sheets,together with the underlying market and oper-ating assumptions;• capital spending plans; and• financing alternatives and contingency plans.It should be understood that Standard &

Poor’s ratings are not based on the issuer’sfinancial projections or management’s view ofwhat the future may hold. Rather, ratings arebased on Standard & Poor’s own assessmentof the firm’s prospects. But management’sfinancial projections are a valuable tool in therating process, as they indicate management’splans, how management assesses the compa-ny’s challenges, and how it intends to deal withproblems. Projections also depict the compa-ny’s financial strategy in terms of anticipatedreliance on internal cash flow or outside funds,and they help articulate management’s finan-cial objectives and policies.

Management meetings with companies newto the rating process typically last two to fourhours—or longer if the company’s operationsare particularly complex. If the issuer is domi-ciled in a country new to ratings or partici-pates in a new industry, more time is usuallyrequired. When, in addition, there are major



Requestrating

Meetissuer

Ratingcommitteemeeting

Appealsprocess

Issuerating Surveillance

Assign analytical team

Conduct basic research

Standard & Poor’s debt rating process


accounting issues to be covered, meetings canlast a full day or two.

Short, formal presentations by managementmay be useful to introduce areas for discus-sion. Standard & Poor’s preference is for meet-ings to be largely informal, with ample timeallowed for questions and responses. (At man-agement meetings, as well as at all other times,Standard & Poor’s welcomes the company’squestions regarding its procedures, methodol-ogy, and analytical criteria.)

Rating committeeShortly after the issuer meeting, a rating

committee, normally consisting of five to sevenvoting members, is convened. A presentation ismade by the industry analyst to the ratingcommittee, which has been provided withappropriate financial statistics and compara-tive analysis. The presentation follows themethodology outlined in the next sections ofthis volume. Thus, it includes analysis of thenature of the company’s business and its oper-ating environment, evaluation of the compa-ny’s strategic and financial management, finan-cial analysis, and a rating recommendation.When a specific issue is to be rated, there is anadditional discussion of the proposed issue andterms of the indenture.

Once the rating is determined, the companyis notified of the rating and the major consid-erations supporting it. It is Standard & Poor’spolicy to allow the issuer to respond to the rat-ing decision prior to its publication by present-ing new or additional data. Standard & Poor’sentertains appeals in the interest of havingavailable the most information possible and,thereby, the most accurate ratings. In the caseof a decision to change an extant rating, anyappeal must be conducted as expeditiously aspossible, i.e., with a day or two. The commit-tee reconvenes to consider the new informa-tion. After notifying the company, the rating isdisseminated in the media—or released to thecompany for dissemination in the case of pri-vate placements or corporate credit ratings.

In order to maintain the integrity and objec-tivity of the rating process, Standard & Poor’sinternal deliberations and the identities of per-sons who sat on a rating committee are keptconfidential and are not disclosed to the issuer.

Surveillance Corporate ratings on publicly distributed

issues are monitored for at least one year. Thecompany can then elect to pay Standard &Poor’s to continue surveillance. Ratingsassigned at the company’s request have theoption of surveillance, or being on a “point-in-time” basis.

Surveillance is performed by the same indus-try analysts who work on the assignment ofthe ratings. To facilitate surveillance, compa-nies are requested to put the primary analyston mailing lists to receive interim and annualfinancial statements and press releases.

The primary analyst is in periodic telephonecontact with the company to discuss ongoingperformance and developments. Where thesevary significantly from expectations, or wherea major, new financing transaction is planned,an update management meeting is appropriate.Also, Standard & Poor’s encourages compa-nies to discuss hypothetically—again, in strictconfidence—transactions that are perhapsonly being contemplated (e.g., acquisitions,new financings), and it endeavors to providefrank feedback about the potential ratingsimplications of such transactions.

In any event, management meetings are rou-tinely scheduled at least annually. These meet-ings enable analysts to keep abreast of man-agement’s view of current developments, dis-cuss business units that have performed differ-ently from original expectations, and beapprised of changes in plans. As with initialmanagement meetings, Standard & Poor’swillingly provides guidance in advance regard-ing areas it believes warrant emphasis at themeeting. Typically, there is no need to dwell onbasic information covered at the initial meet-ing. Apart from discussing revised projections,it is often helpful to revisit the prior projec-tions and to discuss how actual performancevaried, and why.

A significant and increasing proportion ofmeetings with company officials takes place onthe company’s premises. There are several rea-sons: to facilitate increased exposure to man-agement personnel—particularly at the operat-ing level, obtain a first-hand view of new ormodernized facilities, and achieve a betterunderstanding of the company by spending


more time reviewing the business units indepth. While Standard & Poor’s activelyencourages meetings on company premises,time and scheduling constraints on both sidesdictate that arrangements for these meetings bemade some time in advance.

Since the staff is organized by specialty, ana-lysts typically meet each year with most majorcompanies in their assigned area to discussindustry outlook, business strategy, and finan-cial forecasts and policies. This way, competi-tors’ forecasts of market demand can be com-pared with one another, and Standard &Poor’s can assess implications of competitors’strategies for the entire industry. The analystcan judge management’s relative optimismregarding market growth and relative aggres-siveness in approaching the marketplace.

Importantly, the analyst compares businessstrategies and financial plans over time andseeks to understand how and why theychanged. This exercise provides insightsregarding management’s abilities with respectto forecasting and implementing plans. Bymeeting with different managements over thecourse of a year and the same managementyear after year, analysts learn to distinguishbetween those with thoughtful, realistic agen-das versus those with wishful approaches.

Management credibility is achieved whenthe record demonstrates that a company’s

actions are consistent with its plans and objec-tives. Once earned, credibility can help to sup-port continuity of a particular rating level—because Standard & Poor’s can rely on man-agement to do what it says to restore credit-worthiness when faced with financial stress oran important restructuring. The rating processbenefits from the unique perspective on credi-bility gained by extensive evaluation of man-agement plans and financial forecasts overmany years.

Rating changesAs a result of the surveillance process, it

sometimes becomes apparent that changingconditions require reconsideration of the out-standing debt rating. When this occurs, theanalyst undertakes a preliminary review, whichmay lead to a CreditWatch listing. This is fol-lowed by a comprehensive analysis, communi-cation with management, and a presentationto the rating committee. The rating committeeevaluates the matter, arrives at a rating deci-sion, and notifies the company—after whichStandard & Poor’s publishes the rating. Theprocess is exactly the same as the rating of anew issue.

Reflecting this surveillance, the timing ofrating changes depends neither on the sale ofnew debt issues nor on Standard & Poor’sinternal schedule for reviews.



Rating Methodology:Evaluating the Issuer

RATING METHODOLOGY � Corporate Ratings Criteria 17

Standard & Poor’s uses a format that dividesthe analytical task into several categories, pro-viding a framework that ensures all salientissues are considered (see box). For corporates,the first several categories are oriented to fun-damental business analysis; the remainderrelate to financial analysis. As further analyti-cal discipline, each category is scored in thecourse of the ratings process, and there arealso scores for the overall business risk profileand the overall financial risk profile.(Analytical groups choose various ways toexpress these scores: Some use letter symbols,while others prefer to use numerical scoringsystems. For example, utilities scoring is from1 to 10—with 1 representing the best.Companies with a strong business profile—typically, transmission/distribution utilities—are scored 1 through 4; those facing greatercompetitive threats—such as power genera-tors—would wind up with an overall businessprofile score of 7 to 10.)

There are no formulae for combining scoresto arrive at a rating conclusion. Bear in mindthat ratings represent an art as much as a sci-ence. A rating is, in the end, an opinion. Indeed,it is critical to understand that the rating processis not limited to the examination of variousfinancial measures. Proper assessment of debtprotection levels requires a broader framework,involving a thorough review of business funda-mentals, including judgments about the compa-ny’s competitive position and evaluation ofmanagement and its strategies. Clearly, suchjudgments are highly subjective; indeed, subjec-tivity is at the heart of every rating.

At times, a rating decision may be influencedstrongly by financial measures. At other times,business risk factors may dominate. If a firm isstrong in one respect and weak in another, therating will balance the different factors.Viewed differently, the degree of a firm’s busi-ness risk sets the expectations for the financialrisk it can afford at any rating level. The

analysis of industry characteristics and how afirm is positioned to succeed in that environ-ment establish the financial benchmarks usedin the quantitative part of the analysis (SeeRatio Guidelines on pages 56-58).

Industry riskEach rating analysis begins with an assess-

ment of the company’s environment. To deter-mine the degree of operating risk facing a par-ticipant in a given business, Standard & Poor’sanalyzes the dynamics of that business. Thisanalysis focuses on the strength of industryprospects, as well as the competitive factorsaffecting that industry.

The many factors assessed include industryprospects for growth, stability, or decline, andthe pattern of business cycles (see Cyclicality,page 41). It is critical to determine vulnerabili-ty to technological change, labor unrest, orregulatory interference. Industries that havelong lead times or that require a fixed plant ofa specialized nature face heightened risk. The

Industrials and Utilities


CORPORATE CREDIT ANALYSIS FACTORS

Business RiskIndustry Characteristics Competitive Position

(e.g.) Marketing(e.g.) Technology(e.g.) Efficiency(e.g.) Regulation

ManagementFinancial Risk

Financial CharacteristicsFinancial PolicyProfitabilityCapital StructureCash Flow ProtectionFinancial Flexibility

implications of increasing competition areobviously crucial. Standard & Poor’s knowl-edge of investment plans of the major playersin any industry offers a unique vantage pointfrom which to assess competitive prospects.

While any particular profile category can bethe overriding rating consideration, the industryrisk assessment goes a long way toward settingthe upper limit on the rating to which any par-ticipant in the industry can aspire. Specifically, itwould be hard to imagine assigning ‘AA’ and‘AAA’ debt ratings or ‘A-1+’ commercial paperratings to companies with extensive participa-tion in industries of above-average risk, regard-less of how conservative their financial posture.Examples of these industries are integrated steelmakers, tire and rubber companies, home-builders, and most of the mining sector.

Conversely, some industries are regardedfavorably. They are distinguished by such traitsas steady demand growth, ability to maintainmargins without impairing future prospects,flexibility in the timing of capital outlays, andmoderate capital intensity. Industries possess-ing one or more of these attributes includemanufacturers of branded consumer products,drug firms, and publishing and broadcasting.Again, high marks in this category do nottranslate into high ratings for all industry par-ticipants, but the cushion of strong industryfundamentals provides helpful support.

The industry risk assessment also sets thestage for analyzing specific company risk fac-tors and establishing the priority of these fac-tors in the overall evaluation. For example, ifan industry is determined to be highly compet-itive, careful assessment of a firm’s marketposition is stressed. If the industry has largecapital requirements, examination of cash flowadequacy assumes major importance.

Keys to successAs part of the industry analysis, key rating

factors are identified: the keys to success andareas of vulnerability. A company’s rating isaffected crucially by its ability to achieve suc-cess and avoid pitfalls in its business.

The nature of competition is, obviously,different for different industries. Competitioncan be based on price, quality of product,distribution capabilities, image, product differ-entiation, service, or some other factor.Competition may be on a national basis, as isthe case with major appliances. In other indus-tries, such as chemicals, competition is global,

and in still others, such as cement, competitionis strictly regional.

The basis for competition determines whichfactors are analyzed for a given company. Theaccompanying charts highlight factors that areconsidered critical for airlines and electricitycompanies and the specific considerations thatdetermine a company’s position in each.

For any particular company, one or morefactors can hold special significance, even ifthat factor is not common to the industry. Forexample, the fact that a company has only onemajor production facility should certainly beregarded as an area of vulnerability. Similarly,reliance on one product creates risk, even if theproduct is highly successful. For example, onemajor pharmaceutical company has reaped afinancial bonanza from just two medications.The firm’s debt is reasonably highly rated,given its exceptional profits and cash flow—but it would be viewed still more favorablywere it not for the dependence on only twodrugs (which are, after all, subject to competi-tion and patent expiration).

Diversification factorsWhen a company participates in more than

one business, each segment is separately ana-lyzed. A composite is formed from these build-ing blocks, weighting each element accordingto its importance to the overall organization.The potential benefits of diversification, whichmay not be apparent from the additiveapproach, are then considered.

Obviously, the truly diversified companywill not have a single business segment that isdominant. One major automobile companyreceived much attention for diversifying intoaerospace and computer processing. But itnever became a diversified firm, since its suc-cess was still determined substantially by oneline of business.

Limited credit will be given if the various linesof business react similarly to economic cycles. Forexample, diversification from nickel into coppercannot be expected to stabilize performance; sim-ilar risk factors are associated with both metals.

Most critical is a company’s ability to man-age diverse operations. Skills and practicesneeded to run a business differ greatly amongindustries, not to mention the challenge posedby participation in several different industries.For example, a number of old-line industrialfirms rushed to diversify into financial ser-vices, only to find themselves saddled with

18 RATING METHODOLOGY � Corporate Ratings Criteria



unfamiliar businesses they had difficultymanaging.

Some firms have adopted a portfolioapproach to their diverse holdings. The busi-ness of buying and selling businesses is differ-ent from running operations and is analyzeddifferently. The ever-changing character of thecompany’s assets typically is viewed as a nega-tive. On the other hand, there is often an off-setting advantage: greater flexibility in raisingfunds if each line of business is a discrete unitthat can be sold off.

Size considerationsStandard & Poor’s has no minimum size cri-

terion for any given rating level. However, sizeusually provides a measure of diversificationand often affects competitive issues.Obviously, the need to have a broad productline or a national marketing structure is a fac-tor in many businesses and would be a ratingconsideration. In this sense, sheer mass is notimportant; demonstrable market advantage is.Small companies also can possess the competi-tive benefits of dominant market positions,although that is not common.

Market share analysis often provides impor-tant insights. However, large shares are notalways synonymous with competitive advan-tage or industry dominance. For instance, if anindustry has a number of large but compara-ble-size participants, none may have a particu-lar advantage or disadvantage. Conversely, ifan industry is highly fragmented, even thelarge firms may lack pricing leadership poten-tial. The textile industry is an example.

Still, small companies are, almost by defini-tion, more concentrated in terms of product,number of customers, or geography. In effect,they lack some elements of diversification thatcan benefit larger firms. To the extent thatmarkets and regional economies change, abroader scope of business affords protection.This consideration is balanced against the per-formance and prospects of a given business. Inaddition, lack of financial flexibility is usuallyan important negative factor in the case of verysmall firms. Adverse developments that wouldsimply be a setback for firms with greaterresources could spell the end for companieswith limited access to funds.

There is a controversial notion that small,growth companies represent a better credit riskthan older, declining companies. While this isintuitively appealing to some, it ignores some

important considerations. Large firms havesubstantial staying power, even if their busi-nesses are troubled. Their constituencies—including large numbers of employees—caninfluence their fates. Banks’ exposure to thesefirms may be quite extensive, creating a reluc-tance to abandon them. Moreover, such firmsoften have accumulated a lot of peripheralassets that can be sold. In contrast, the promiseof small firms can fade very quickly and theirminuscule equity bases will offer scant protec-tion, especially given the high debt burdensome companies deliberately assume.

Fast growth is often subject to poor execu-tion, even if the idea is well conceived. Thereis also the risk of overambitiousness.Moreover, some firms tend to continue high-risk financial policies as they aggressively pur-sue ever greater objectives, limiting any cred-it-quality improvement. There is little evi-dence to suggest that growth companies ini-tially receiving speculative-grade ratings haveparticular upgrade potential. Many moredefaulted over time than achieved investmentgrade. Oil exploration, retail, and high tech-nology firms have been especially vulnerable,even though their great potential was toutedat the time they first came to market.

Management evaluationManagement is assessed for its role in deter-

mining operational success and also for its risktolerance. The first aspect is incorporated inthe competitive position analysis; the second isweighed as a financial policy factor.

Subjective judgments help determine eachaspect of management evaluation. Opinionsformed during the meetings with senior man-agement are as important as management’strack record. While a track record may seem tooffer a more objective basis for evaluation, itoften is difficult to determine how resultsshould be attributed to management’s skills.The analyst must decide to what extent theyare the result of good management, devoid ofmanagement influence, or achieved despitemanagement!

Plans and policies have to be judged for theirrealism. How they are implemented deter-mines the view of management consistencyand credibility. Stated policies often are notfollowed, and the ratings will reflect skepti-cism unless management has established credi-bility. Credibility can become a critical issuewhen a company is faced with stress or




Transmission and Distribution CompaniesRegulation• The nature of the rate-making structure,

e.g., performance-based vs. cost-of-service• Authorized return on equity• Timely and consistent rate treatment• Status of restructuring, e.g., residual

obligation to provide power, whichentails the purchase of electricity forresale

• FERC’s evolving rules for regional trans-mission of organizations, independentsystem operators, and for-profit transcos

• Incentives to maintain existing deliveryassets and invest in new assets

• Nature of distributor support that retainsthe status of provider of last resort

Markets• Economic and demographic characteris-

tics, including size and growth rates,customer mix, industrial concentrations,and cyclical volatility

• LocationOperations• Cost, reliability, and quality of service

(usually measured against various bench-marks)

• Capacity utilization• Projected capital improvements• Nature of diversified business operations,

if anyCompetitiveness• Alternative fuel sources, such as gas and

self-generation• Location of new generation• Potential for bypass• Rate Structure

Generation CompaniesRegulation• Status of restructuring, e.g., posture

toward recovery of stranded costs• Nature of regulatory scheme, e.g., price

establishment through power exchange oreconomic dispatch vs. bilateral contracts

• Uncertainty concerning FERC’s evolvingrules for regional transmission organiza-tions, independent system operators, andfor-profit transcos, including indepen-dence and equal access

Markets• Customer mix and diversity• Generating capacity vs. demand• Economic growth prospectsOperations• Nature of generation, i.e., peaking, inter-

mediate, or baseload• Production inputs, including fuel costs,

fuel diversity, and labor• Level of physical and financial hedging

sophistication• Nature of supply contracts• Efficiency measures, such as plant capaci-

ty and availability factors and heat rates• Technology of plants• Asset concentration within portfolio of

generating units• Construction risk• Possibility of environmental legislation• Diversity of fuel sources and types• Marketing prowess• Access to transmissionCompetitiveness• Relative costs of production, both total

and variable• Threat from new, low-cost entrants• Alternatives to electricity, such as natural

gas, technological innovations, andremote site applications, including fuelcells and microturbines

• Plants’ importance to transmission andvoltage support

RATING FACTORS FOR ELECTRIC UTILITIES



Market ShareShare of industry traffic, measured by rev-

enue passenger miles or revenue tonmiles for airlines with significant freightoperations

Share of industry capacity, measured byavailable seat miles or available ton miles

Trend of overall market shareMembership in global alliance: strength of

rated, regulatory environment foralliance cooperation (e.g. “antitrustimmunity”), extent of and potential forcooperation within alliance

Position in Specific MarketsGeographic position of airline’s hubs for

handling major traffic flows; position ofcompeting hubs of other airlines

Share of enplanements and flights at hubsShare at major origination and destination

markets; economic and demographicgrowth prospects of those markets

Strength of competition at hubs and inmajor markets served

Barriers to entry/infrastructure constraintsGatesTerminal space and other ground

facilitiesAir traffic control; takeoff and landing

slot restrictionsPosition in international markets

Growth prospects of marketsTreaty and regulatory barriers to entryStrength of competition

Revenue GenerationUtilization of capacity, measured by “load

factor” (revenue passenger miles dividedby available seat miles)

PricingYield (passenger revenues divided by

revenue passenger miles)Yield adjusted for average trip length

(Airlines with shorter average trips tend to have higher yields.)

Unit revenues, measured by passenger rev-enue per available seat mile (yield timesload factor)

Effectiveness of revenue management—maximizing revenues by managing trade-off between pricing and utilization

Service reputation; ranking in measures ofcustomer satisfaction

Nonpassenger revenues: freight, sale offrequent flyer miles, services provided toother airlines

Cost ControlOperating cost per available seat mile

Adjusted for average trip length Adjusted for use of operating leases

and differing depreciation accountingLabor

Labor cost per available seat mileStructure of labor contracts; existence

and nature of any “B-scales” (lower pay scales for recent hires)

Flexibility of work rules; effect on productivity

“Scope clauses” in pilot contracts; limits on outsourcing

Status of union contracts and negoti-tions; possibility of strikes

Labor relations and moraleFuel costs and impact of potential fuel price

hikes, given fuel efficiency of fleet andnature of routes flown; fuel price hedging

Commissions, marketing, and other operatingexpenses; extent of “electronic distribution”

Aircraft FleetNumber and type of aircraft in relation to

current and projected needsStatus of fleet modernization program

Average age fleet; age weighted by seats

Fleet “commonality” (standardization)Fuel efficiency of fleetAircraft orders and options for future

deliveriesAbility under pilot contracts to operateregional jets, through airline or itsregional partners

RATING FACTORS FOR AIRLINES

partners and benefits for airline being

restructuring and the analyst must decidewhether to rely on management to carry outplans for restoring creditworthiness.

Organizational considerationsStandard & Poor’s evaluation is sensitive to

potential organizational problems. Theseinclude situations where:

• There is significant organizational relianceon an individual, especially one who may beclose to retirement;• The finance function and finance consid-erations do not receive high organizationalrecognition;• The transition from entrepreneurial or family-bound to professional management has yetto be accomplished;• A relatively large number of changes occurwithin a short period;• The relationship between organizationalstructure and management strategy isunclear;• Shareholders impose constraints on man-agement prerogatives.

Measuring performance and riskHaving evaluated the issuer’s competitive

position and operating environment, theanalysis proceeds to several financial cate-gories. To reiterate: the company’s business-risk profile determines the level of financialrisk appropriate for any rating category.Financial risk is portrayed largely throughquantitative means, particularly by usingfinancial ratios (guidelines and medians forkey ratios for U.S. companies are found onpages 54 and 57). Benchmarks vary greatly byindustry, and several analytical adjustmentstypically are required to calculate ratios for anindividual company. Cross-border compar-isons require additional care, given the differ-ences in accounting conventions and localfinancial systems (see discussion on interna-tional rating issues starting on page 30).

Accounting qualityRatings rely on audited data, and the rating

process does not entail auditing a company’sfinancial records. Analysis of the audited finan-cials begins with a review of accounting quali-ty. The purpose is to determine whether ratiosand statistics derived from financial statementscan be used accurately to measure a company’sperformance and position relative to both itspeer group and the larger universe of industrial

or utility companies. The rating process is verymuch one of comparisons, so it is important tohave a common frame of reference.

Accounting issues to be reviewed include:• Consolidation basis. U.S. GAAP now

requires consolidation of even nonhomoge-neous operations. For analytical purposes, it iscritical to separate these and evaluate eachtype of business in its own right;

• Income recognition. For example, percent-age of completion vs. completed contract inthe construction industry;

• Depreciation methods and asset lives;• Inventory pricing methods;• Impact of purchase accounting and treat-

ment of goodwill;

and• Various off-balance-sheet liabilities, from

leases and project finance to defeasance andreceivable sales.

To the extent possible, analytical adjust-ments are made to better portray reality.Although it is not always possible to complete-ly recast a company’s financial statements, it isuseful to have some notion of the extent per-formance or assets are overstated or understat-ed. At the very least, the choice of accountingalternatives can be characterized as generallyconservative or liberal.

Financial policyStandard & Poor’s attaches great impor-

tance to management’s philosophies and poli-cies involving financial risk. A surprising num-ber of companies have not given this questionserious thought, much less reached strong con-clusions. For many others, debt leverage (cal-culated without any adjustment to reportedfigures) is the only focal point of such policyconsiderations. More sophisticated businessmanagers have thoughtful policies that recog-nize cash-flow parameters and the interplaybetween business and financial risk.

Many firms that have set goals do not havethe wherewithal, discipline, or managementcommitment to achieve these objectives. Acompany’s leverage goals, for example, need tobe viewed in the context of its past record andthe financial dynamics affecting the business. Ifmanagement states, as many do, that its goal isto operate with 35% debt-to-capital, Standard& Poor’s factors that into its analysis only tothe extent it appears plausible. For example, ifa company has aggressive spending plans, that



• Employee benefits (see discussion on page 105);


35% goal would carry little weight, unlessmanagement has committed to a specific pro-gram of asset sales, equity sales, or otheractions that in a given time period would pro-duce the desired results.

Standard & Poor’s does not encourage com-panies to manage themselves with an eyetoward a specific rating. The more appropriateapproach is to operate for the good of the busi-ness as management sees it, and let the ratingfollow. Certainly, prudence and credit qualityshould be among the most important consider-ations, but financial policy should be consis-tent with the needs of the business rather thanan arbitrary constraint.

If opportunities are foregone merely to avoidfinancial risk, the firm is making poor strategicdecisions. In fact, it may be sacrificing long-term credit quality for the facade of low risk inthe near term. One financial article described acompany that curtailed spending expressly “tobecome an ‘A’-rated company.” As a result,“...the company’s business responded poorlyto an increase in market demand. Needless tosay, the sought-after ‘A’ rating continued toelude the company.”

In any event, pursuit of the highest ratingattainable is not necessarily in the company’sbest interests. ‘AAA’ may be the highest rating,but that does not suggest that it is the “best”rating. Typically, a company with virtually nofinancial risk is not optimal as far as meetingthe needs of its various constituencies. Anunderleveraged firm is not minimizing its costof capital, thereby depriving its owners ofpotentially greater value for their investment.In this light, a corporate objective of having itsdebt rated ‘AAA’ or ‘AA’ is at times suspect.Whatever a company’s financial track record,an analyst must be skeptical if corporate goalsare implicitly irrational. A firm’s “conservativefinancial philosophy” must be consistent withthe firm’s overall goals and needs.

Profitability and coverageProfit potential is a critical determinant of

credit protection. A company that generateshigher operating margins and returns on capi-tal has a greater ability to generate equity cap-ital internally, attract capital externally, andwithstand business adversity. Earnings powerultimately attests to the value of the firm’sassets as well.

The more significant measures of profitabil-ity are:

• Pretax preinterest return on capital;• Operating income as a percentage of sales;and• Earnings on business segment assets.While the absolute levels of ratios are impor-

tant, it is equally important to focus on trendsand compare these ratios with those of com-petitors. Various industries follow differentcycles and have different earnings characteris-tics. Therefore, what may be considered favor-able for one business may be relatively poor foranother. For example, the drug industry usual-ly generates high operating margins and highreturns on capital. Defense contractors gener-ate low operating margins, but high returns oncapital. The pipeline industry has high operat-ing margins and low returns on capital.Comparisons with a company’s peers influenceStandard & Poor’s perception of a firm’s com-petitive strengths and pricing flexibility.

The analysis proceeds from historical perfor-mance to projected profitability. Because a rat-ing is an assessment of the likelihood of timelypayments in the future, the evaluation empha-sizes future performance. However, the ratinganalysis does not attempt to forecast perfor-mance precisely or to pinpoint economic cycles.Rather, the forecast analysis considers variabil-ity of expected future performance based on arange of economic and competitive scenarios.

Particularly important today are manage-ment’s plans for achieving earnings growth.Can existing businesses provide satisfactorygrowth, especially in a low-inflation environ-ment, and to what extent are acquisitions ordivestitures necessary to achieve corporategoals? At first glance, a mature, cash-generat-ing company offers a great deal of bondholderprotection, but Standard & Poor’s assumes acorporation’s central focus is to augment share-holder value over the long run. In this context,a lack of indicated earnings growth potential isconsidered a weakness. By itself this may hin-der a company’s ability to attract financial andhuman resources. Moreover, limited internalearnings growth opportunities may lead man-agement to pursue growth externally, implyinggreater business and financial risks.

Earnings are also viewed in relation to acompany’s burden of fixed charges. Otherwise-strong performance can be affected detrimen-tally by aggressive debt financing, and theopposite also is true. The two primary fixed-charge coverage ratios are:


• Earnings before interest and taxes (EBIT)coverage of interest; and• Earnings before interest and taxes and rent(EBITR) coverage of interest plus total rents. If preferred stock is outstanding and materi-

al, coverage ratios are calculated both includ-ing and excluding preferred dividends, toreflect the company’s discretion over payingthe dividend when under stress. Similarly, ifinterest payments can be deferred (as in zerocoupon debt, income bonds, or intercompanydebt supporting subsidiary preferred stock)other adjustments to the calculation help cap-ture the firm’s flexibility in making payments.

To reflect more accurately the ongoing earn-ings power of the firm, reported profit figuresare adjusted. These adjustments remove theeffect of

• LIFO liquidations,• Foreign-exchange gains and losses,• Litigation reserves,• Writedowns and other nonrecurring or extra-ordinary gains and losses, and • Unremitted equity earnings of a subsidiary.Similarly, there are numerous analytical

adjustments to the interest amounts. Interestthat has been capitalized is added back. Aninterest component is computed for debt-equivalents such as operating leases and receiv-able sales. Amounts may be subtracted to rec-ognize the impact of borrowings in hyperinfla-tionary environments or borrowings to sup-port cash investments as part of a tax arbitragestrategy. And interest associated with financeoperations is segregated in accordance with the

Capital structure/leverage and asset protection

Ratios employed by Standard & Poor’s tocapture the degree of leverage used by a com-pany include:

• Total debt/total debt + equity;• Total debt + off-balance-sheet liabilities/totaldebt + off-balance-sheet liabilities + equity; and• Total debt/total debt + market value ofequity.Traditional measures focusing on long-term

debt have lost much of their significance, sincecompanies rely increasingly on short-term bor-rowings. It is now commonplace to find per-manent layers of short-term debt, whichfinance not only seasonal working capital butalso an ongoing portion of the asset base.

What is considered “debt” and “equity” forthe purpose of ratio calculation is not alwaysso simple. In the case of hybrid securities, theanalysis is based on their features—not theaccounting or the nomenclature (see discussion

retiree health obligations are similar to debt inmany respects. Their treatment is explained on

Indeed, not all subtleties and complexitieslend themselves to ratio analysis. Originalissue discount debt, such as zero coupon debt,is included at the accreted value. However,since there is no sinking fund provision, thedebt increases with time—creating a movingtarget. (The need, eventually, to refinance thisgrowing amount represents another risk.) Inthe case of convertible debt, it is somewhatpresumptuous to predict whether and whenconversion will occur, making it difficult toreflect the real risk profile in ratio form.

A company’s asset mix is a critical determi-nant of the appropriate leverage for a givenlevel of risk. Assets with stable cash flow ormarket values justify greater use of debtfinancing than those with clouded marketabil-ity. For example, grain or tobacco inventorywould be viewed positively, compared withapparel or electronics inventory; transporta-tion equipment is viewed more favorably thanother equipment, given its suitability for use byother companies.

Accordingly, if a firm operates different busi-nesses, Standard & Poor’s believes it is criticalto analyze each type of business and asset classin its own right. While FASB and IAS nowrequire consolidation of nonhomogenous busi-ness units, Standard & Poor’s analyzes eachseparately. This is the basis for Standard &Poor’s methodology for analyzing captive

a company holds significant amounts of excesscash or investments, ratios may be calculatedon a “net debt” basis. This approach is used inthe case of cash-rich pharmaceutical firms thatenjoy tax arbitrage opportunities with respectto these cash holdings.

Asset valuationKnowing the true values to assign a company’s

assets is key to the analysis. Leverage as report-ed in the financial statements is meaningless ifassets are materially undervalued or overvaluedrelative to book value. Standard & Poor’s con-siders the profitability of an asset as an appro-



methodology spelled out on page 103.

page 105.

finance companies (see page 102). Similarly, if

of “equity credit” on page 89). Pension and


priate basis for determining its economic value.Market values of a company’s assets orindependent asset appraisals can offer addition-al insights. However, there are shortcomings inthese methods of valuation (just as there are withhistorical cost accounting) that prevent relianceon any single measure. Similarly, ratios using themarket value of a company’s equity in calcula-tions of leverage are given limited weight as ana-lytical tools. The stock market emphasizesgrowth prospects and has a short time horizon;it is influenced by changes in alternative invest-ment opportunities and can be very volatile. Acompany’s ability to service its debt is not affect-ed directly by such factors.

The analytical challenge of which values touse is especially evident in the case of mergedand acquired companies. Accounting stan-dards allow the acquired company’s assets andequity to be written up to reflect the acquisi-tion price, but the revalued assets have thesame earning power as before; they cannotsupport more debt just because a differentnumber is used to record their value! Rightafter the transaction, the analysis can takethese factors into account, but down the roadthe picture becomes muddied. Standard &Poor’s attempts to normalize for purchaseaccounting, but the ability to relate to pre-acquisition financial statements and to makecomparisons with peer companies is limited.

Presence of a material goodwill accountindicates the impact of acquisitions and pur-chase accounting on a firm’s equity base.Intangible assets are no less “valuable” thantangible ones. But comparisons are still dis-torted, since other companies cannot recordtheir own valuable business intangibles, thosethat have been developed instead of acquired.This alone requires some analytical adjustmentwhen measuring leverage. In addition, analystsare entitled to be more skeptical about earningprospects that rely on turnaround strategies or“synergistic” mergers.

Off-balance-sheet financingOff-balance-sheet items factored into the

leverage analysis include the following:• Operating leases;• Debt of joint ventures and unconsolidatedsubsidiaries;• Guarantees;• Take-or-pay contracts and obligations underthroughput and deficiency agreements;

• Receivables that have been factored, trans-ferred, or securitized; and• Contingent liabilities, such as potential legaljudgments or lawsuit settlements.Various methodologies are used to deter-

mine the proper adjustment value for each off-balance-sheet item. In some cases, the adjust-ment is straightforward. For example, theamount of guaranteed debt can simply beadded to the guarantor’s liabilities. Otheradjustments are more complex or less precise.

Nonrecourse debt of a joint venture may beattributed to the parent companies, especially ifthey have a strategic tie to the operation. Theanalysis may burden one parent with a dispro-portionate amount of the debt if that parent hasthe greater strategic interest or operating con-trol or its ability to service the joint-venture debtis greater. Other considerations that affect acompany’s willingness to walk away from suchdebt—and other nonrecourse debt—includeshared banking relationships and commoncountry location. In some instances the debtmay be so large in relation to the owner’s invest-ment that the incentives to support the debt areminimized. In virtually all cases, though, theparent would likely invest additional amountsbefore deciding to abandon the venture.Accordingly, adjustments would be made toreflect the owner’s current and projected invest-ment, even if the venture’s debt were not added

In the case of contingencies, estimates aredeveloped. Insurance coverage is estimated,and a present value is calculated if the pay-ments will stretch over many years. The result-ing amount is viewed as a corporate liabilityfrom an analytical perspective.

The sale or securitization of accountsreceivable represents a form of off-balance-sheet financing. If used to supplant otherdebt, the impact on credit quality is neutral.(There can be some incremental benefit to theextent that the company has expanded accessto capital, and this financing may be lower incost. However, there may also be an offset inthe higher cost of unsecured financing.) Forratio calculations, Standard & Poor’s addsback the amount of receivables and a likeamount of debt. This eliminates the distort-ing, cosmetic effect of utilizing an off-bal-ance-sheet technique and allows better com-parison with other firms that have chosenother avenues of financing. Similarly, if a firm


to the parent’s balance sheet. (See page 98.)

uses proceeds from receivables sales to investin riskier assets—and not to reduce otherdebt—the adjustment will reveal an increasein financial risk.

The debt-equivalent value of operating leas-es is determined by calculating the presentvalue of minimum operating lease obligationsas reported in the annual report’s footnotes.The lease amount beyond five years is assumedto mature at a rate approximating the mini-mum payment due in year five.

The variety of lease types may require theanalyst to obtain additional information oruse estimates to evaluate lease obligations.This is needed whenever lease terms are short-er than the assets’ expected economic lives.For example, retailers report only the firstperiod of a lease written with an initial periodand several renewal options over a long term.Another limitation develops when a portion ofthe lease payment is contingent, e.g., a per-centage of sales, as is often the case in theretailing industry.

(Traditionally, operating leases were recog-nized by the “factor method”: annual leaseexpense is multiplied by a factor that reflectsthe average life of the company’s leased assets.This method is an attempt to capitalize theasset, rather than just the use of the asset forthe lease period. However, the method canoverstate the asset to be capitalized by failingto recognize asset use over the course of thelease. It also is too arbitrary to be realistic.)

Preferred stockPreferred stocks can qualify for treatment as

equity or be viewed as debt—or somethingbetween debt and equity—depending on theirfeatures and the circumstances. The degree ofequity credit for various preferreds is discussed

rity receive diminishing equity credit as theyprogress toward maturity.

A preferred that the analyst believes will beeventually refinanced with debt is viewed as adebt-equivalent, not equity, all along. Auctionpreferreds, for example, are “perpetual” onthe surface. However, they often representmerely a temporary debt alternative for com-panies that are not current taxpayers—untilthey once again can benefit from taxdeductibility of interest expense. Moreover, theholders of these preferreds would pressure fora redemption in the event of a failed auction oreven a rating downgrade.

Redeemable preferred stock issues may alsobe refinanced with debt once an issuerbecomes a taxpayer. Preferreds that can beexchanged for debt at the company’s optionalso may be viewed as debt in anticipation ofthe exchange. However, the analysis wouldalso take into account any offsetting positivesassociated with the change in tax status. Oftenthe trigger prompting an exchange or redemp-tion would be improved profitability. Then,the added debt in the capital structure wouldnot necessarily imply lower credit quality. Theimplications are different for many issuers thatdo not pay taxes for various other reasons,including availability of tax-loss carry-for-wards or foreign tax credits. For them, achange in taxpaying status is not associatedwith better profitability, while the incentive toturn the preferred into debt is identical.

In the same vein, sinking fund preferreds areless equity-like. The sinking fund requirementsthemselves are of a fixed, debt-like nature.Moreover, they are usually met through debtissuance, which results in the sinking fund pre-ferred being just the precursor of debt. Itwould be misleading to view sinking fund pre-ferreds, particularly that portion coming duein the near to intermediate term, as equity,only to have each payment convert to debt onthe sinking fund payment date. Accordingly,Standard & Poor’s views at least the portion ofthe issuer’s sinking fund preferreds due withinthe next five years as debt.

Cash flow adequacyInterest or principal payments cannot be ser-

viced out of earnings, which is just an account-ing concept; payment has to be made withcash. Although there is usually a strong rela-tionship between cash flow and profitability,many transactions and accounting entriesaffect one and not the other. Analysis of cashflow patterns can reveal a level of debt-servic-ing capability that is either stronger or weakerthan might be apparent from earnings.

Cash flow analysis is the single most criti-cal aspect of all credit rating decisions. Ittakes on added importance for speculative-grade issuers. While companies with invest-ment-grade ratings generally have readyaccess to external cash to cover temporaryshortfalls, junk-bond issuers lack this degreeof flexibility and have fewer alternatives tointernally generated cash for servicing debt.



on page 95. Preferred stocks that have a matu-


Cash flow ratiosRatios show the relationship of cash flow to

debt and debt service, and also to the firm’sneeds. Since there are calls on cash other thanrepaying debt, it is important to know theextent to which those requirements will allowcash to be used for debt service or, alternative-ly, lead to greater need for borrowing.

Some of the specific ratios considered are:• Funds from operations/total debt (adjustedfor off-balance-sheet liabilities);• EBITDA/interest;• Free operating cash flow + interest/interest;• Free operating cash flow + interest/interest+ annual principal repayment obligation(debt service coverage);• Total debt/discretionary cash flow (debtpayback period);• Funds from operations/capital spendingrequirements, and• Capital expenditures/capital maintenance.

Where long-term viability is more assured(i.e., higher in the rating spectrum) there can begreater emphasis on the level of funds fromoperations and its relation to total debt burden.These measures clearly differentiate betweenlevels of protection over time. Focusing on debtservice coverage and free cash flow becomesmore critical in the analysis of a weaker com-pany. Speculative-grade issuers typically facenear-term vulnerabilities, which are better mea-sured by free cash flow ratios.

Interpretation of these ratios is not alwayssimple; higher values can sometimes indicateproblems rather than strength. A companyserving a low-growth or declining market mayexhibit relatively strong free cash flow, owingto minimal fixed and working capital needs.Growth companies, in comparison, oftenexhibit thin or even negative free cash flowbecause investment is needed to supportgrowth. For the low-growth company, credit


Discussions about cash flow often sufferfrom lack of uniform definition of terms. Thetable illustrates Standard & Poor’s terminologywith respect to specific cash flow concepts. Atthe top is the item from the funds flow state-ment usually labeled “funds from operations”(FFO) or “working capital from operations.”This quantity is net income adjusted for depre-ciation and other noncash debits and creditsfactored into it. Back out the changes in work-ing capital investment to arrive at “operatingcash flow.”

Next, capital expenditures and cashdividends are subtracted out to arrive at “freeoperating cash flow” and “discretionary cashflow,” respectively. Finally, cost of acquisitionsis subtracted from the running total, proceedsfrom asset disposals added, and other miscel-laneous sources and uses of cash nettedtogether. “Prefinancing cash flow” is the endresult of these computations, which representsthe extent to which company cash flow fromall internal sources has been sufficient tocover all internal needs.

The bottom part of the table reconcilesprefinancing cash flow to various categories of

external financing and changes in the compa-ny’s own cash balance. In the example, XYZInc. experienced a $35.7 million cash shortfallin year one, which had to be met with a com-bination of additional borrowings and a draw-down of its own cash.

Cash flow summary: XYZ Corp.

Year Year(Mil. $) one twoFunds from operations (FFO) 18.58 22.34Dec. (inc.) in noncash current assets (33.12) 1.05Inc. (dec.) in nondebt current liabilities 15.07 (12.61)Operating cash flow 0.52 10.78(Capital expenditures) (11.06) (9.74)Free operating cash flow (10.53) 1.04(Cash dividends) (4.45) (5.14)Discretionary cash flow (14.98) (4.09)(Acquisitions) (21.00) 0.00Asset disposals 0.73 0.23Net other sources (uses) of cash (0.44) (0.09)Prefinancing cash flow (35.70) (3.95)

Inc. (dec.) in short-term debt 23.00 0.00Inc. (dec.) in long-term debt 6.12 13.02Net sale (repurchase) of equity 0.32 (7.07)Dec. (inc.) in cash and securities 6.25 (2.00)

35.70 3.95

MEASURING CASH FLOW

analysis weighs the positives of strong currentcash flow against the danger that this highlevel of protection might not be sustainable.For the high-growth company, the problem isjust the opposite: weighing the negatives of acurrent cash deficit against prospects ofenhanced protection once current investmentbegins yielding cash benefits. There is no sim-ple correlation between creditworthiness andthe level of current cash flow.

The need for capitalAnalysis of cash flow in relation to capital

requirements begins with an examination of acompany’s capital needs, including both work-ing and fixed capital. While this analysis is per-formed for all debt issuers, it is criticallyimportant for fixed capital-intensive firms andgrowth companies. Companies seeking work-ing capital often are able to finance a signifi-cant portion of current assets through tradecredit. However, rapidly growing companiestypically experience a build-up in receivablesand inventories that cannot be financed inter-nally or through trade credit.

Improved working-capital managementtechniques have greatly reduced the investmentthat might otherwise have been required. Thismakes it difficult to base expectations onextrapolating recent trends. In any event,improved turnover experience would not be areason to project continuation of such a trendto yet better levels.

Because Standard & Poor’s evaluates com-panies as ongoing enterprises, the analysisassumes that firms will provide funds continu-ally to maintain capital investments as mod-ern, efficient assets. Cash flow adequacy isviewed from the standpoint of a company’sability to finance capital-maintenance require-ments internally, as well as its ability to financecapital additions. It is difficult to quantify therequirements for capital maintenance unlessdata are provided by the company.

An important dimension of cash flowadequacy is the extent of a company’s flexibil-ity to alter the timing of its capital require-ments. Expansions are typically discretionary.However, large plants with long lead timesusually involve, somewhere along the way, acommitment to complete the project.

There are companies with cash flowadequate to the needs of the existing business,

but that are known to be acquisition-minded.Their choice of acquisition as an avenue forgrowth means that this activity must also beanticipated in the credit analysis.Management’s stated acquisition goals andpast takeover bids, including those that werenot consummated, provide a basis for judgingprospects for future acquisitions.

Financial flexibilityThe previous assessment of financial factors

(profitability, capital structure, cash flow) arecombined to arrive at an overall view of finan-cial health. In addition, sundry considerationsthat do not fit in other categories are exam-ined, including serious legal problems, lack ofinsurance coverage, or restrictive covenants inloan agreements that place the firm at themercy of its bankers.

An analytical task covered at this point is theevaluation of a company’s options understress. The potential impact of various contin-gencies is considered, along with a firm’s con-tingency plans. Access to various capital mar-kets, affiliations with other entities, and abilityto sell assets are important factors.

Flexibility can be jeopardized when a firm isoverly reliant on bank borrowings or commer-cial paper. Reliance on commercial paper with-out adequate backup facilities is a big negative.An unusually short maturity schedule for long-term debt and limited-life preferred stock alsois a negative. Access to various capital marketscan then become an important factor. In gen-eral, a company’s experience with differentfinancial instruments and capital markets givesmanagement alternatives if conditions in a par-ticular financial market suddenly sour.Company size and its financing needs can playa role in whether it can raise funds in the pub-lic debt markets. Similarly, a firm’s role in thenational economy—and this is particularlytrue outside the U.S.—can enhance its access tobank and public funds.

Access to the common stock market may beprimarily a question of management’s willing-ness to accept dilution of earnings per share,rather than a question of whether funds areavailable. (However, in some countries,including Japan and Germany, equity marketsmay not be so accessible.) When a new com-mon stock offering is projected as part of acompany’s financing plan, Standard & Poor’s




tries to measure management’s commitment tothis plan, and its sensitivity to changes inshare price.

As going concerns, companies should not beexpected to repay debt by liquidating opera-tions. Clearly, there is little benefit in sellingnatural resource properties or manufacturingfacilities if these must be replaced in a fewyears. Nonetheless, a company’s ability to gen-erate cash through asset disposals enhances itsfinancial flexibility.

Pension obligations, environmental liabili-ties, and serious legal problems restrict flexi-bility, apart from the obligations’ direct finan-

cial implications. A large pension burden canhinder a company’s ability to sell assets,because potential buyers will be reluctant toassume the liability, or to close excess, ineffi-cient, and costly manufacturing facilities,which might require the immediate recognitionof future pension obligations and result in acharge to equity.

When there is a major lawsuit against thefirm, suppliers or customers may be reluctantto continue doing business, and the company’saccess to capital may also be impaired, at leasttemporarily.


A global rating scale imposes a consistent,common discipline on all cross-border analy-sis, while still allowing the assessment of anissuer in its local context. Standard & Poor’sweighs the diverse national considerations, butexpresses its ratings on a single scale so thatdebtholders can compare issues of equivalentcredit quality.

International corporate ratings are conduct-ed by teams that combine knowledge of thecountry of domicile with industry expertise.The analysis of corporates around the globe allfollow the same rating methodology (describedin the previous section): Industry risk and thecompany’s competitive position are evaluatedin conjunction with the firm’s financial profileand policies. This fundamental analysis is per-formed with an appreciation of relevant indus-try and financial characteristics of a specificcountry or region. If the regional environmentposes additional risks to corporates operatingthere, that too is incorporated in the analysis.(The section starting on page 34 elaborates oncountry economic and political factors thatpertain in emerging markets.)

The analysis is conducted based on theissuer’s financial statements prepared in accor-dance with the prevailing local standard—aslong as these meet international standards andare audited by a reputable firm. In someemerging markets it is critical to resolve inadvance what level of disclosure will be avail-able—at the time of the rating and on an ongo-ing basis (to allow appropriate surveillance.)

Business riskBusiness risk analysis entails the assessment

of an issuer’s economic, operational, and com-petitive environment. The analysis of corpo-rates of differing nationalities calls for anappreciation of this environment for an issuer’sspecific geographical and industrial mix.Demand and supply factors, both domesticand worldwide, are assessed. Industries wherecompetition takes place on a local basis, such

as retailing, are viewed differently than thosewhich are exposed to global market forces,such as semiconductors or energy. Otherindustries, such as automobiles, face a combi-nation of global and regional market consider-ations. Industry risk varies from region toregion.

In reviewing companies in export-orientedcountries, emphasis is placed on a firm’s abili-ty to withstand local currency appreciationand the country’s sentiments toward trade pro-tectionism. Japanese manufacturers, for exam-ple, were challenged in the mid-1980s andagain in the mid-1990s by the strong appreci-ation of the yen relative to the dollar. Laborconditions can also differ internationally.Where labor costs are high, an industrial com-pany’s cost structure can impair its interna-tional competitive position. Differing socialattitudes and legal restrictions regarding labormake headcount reductions or other forms ofindustrial rationalization more difficult incertain countries.

The role of regulation and legislation, actualand potential, must also be considered. InEurope, a growing number of industries areexperiencing challenges to traditional arrange-ments stemming from new directives from theEuropean Economic Commission.

Financial riskKey aspects of financial risk assessed by

Standard & Poor’s include earnings protec-tion, cash flow adequacy, asset quality, use ofdebt leverage, and financial flexibility. It is achallenge to interpret and compare financialmeasures that are derived from differingaccounting practices. For example, some sys-tems use historical cost and others use current,or inflated, cost to value assets.

The analyst begins by assessing companyperformance based on its own accountingframework. Adjustments are made to enablecomparisons. Standard & Poor’s does nottranslate a company’s financial accounts to a



The Global Perspective

U.S. GAAP framework (nor does it ask com-panies to do so.) By understanding the featuresof each accounting system, analysts seek outdifferences that materially affect the way acompany operating under any reporting sys-tem compares with that of its internationalpeer group.

Endeavoring to adjust measurements ofinternational companies to common denomi-nators, the analysis focuses on “real” stocksand flows, namely, levels of debt, cash, andcash flow. There is less emphasis on abstractmeasures, such as shareholders’ equity andreported earnings. Although earnings and networth have important economic meaning ifmeasured consistently and responsibly, thismeaning is often blurred in a cross-border con-text. For example, differing depreciation orasset revaluation policies can result in signifi-cant distortions. In addition, profitabilitynorms differ on an international basis. A com-pany generating relatively low returns on per-manent capital in a country with low interestrates perhaps should be viewed more favorablythan a similar company reporting higherreturns in a higher interest rate environment.

Financial parameters that are increasinglyviewed as relevant and reliable are coverage offixed financial charges by cash flow and oper-ating cash flow relative to total debt. The tra-ditional measure of debt to capital is no longerweighted as heavily. In any event, ratios of cor-porates outside the U.S. are not directly com-parable with median statistics published forU.S. industrials.

Balance-sheet distortionTreatment of goodwill offers an example of

balance-sheet distortion. In some countries,companies write off goodwill at the outset ofan acquisition, whereas companies in otherparts of the world do not. U.K. companiestended to write off goodwill, that is, untilrecent changes in their accounting procedures.The result is that U.K. companies tend to havecapital structures that look weaker and earn-ings that look better than those of competitorsfrom countries that capitalize goodwill andamortize it over time. To adjust, the analystmay add back goodwill to shareholders’ fundsand make a qualitative or quantitative adjust-ment for goodwill amortization in analyzing aU.K. company.

Asset valuation practices also differ fromcountry to country, resulting in differences in

both a company’s reported equity base and itsdepreciation expense. There is no easy way tocompare companies that revalue their assetswith those that do not. Rather, Standard &Poor’s recognizes that, for all companies,reported asset values often differ from marketvalues. In discussions with management,Standard & Poor’s analysts endeavor to gainan appreciation of the realizable values of acompany’s assets under reasonablyconservative assumptions.

Net debtIn many countries, notably in Japan and

Europe, local practice is to maintain a highlevel of debt while holding a large portfolio ofcash and marketable securities. Many compa-nies manage their finances on a net debt basis.In these situations, Standard & Poor’s focuseson net interest coverage, cash flow to net debt,and net debt to capital. When a company con-sistently demonstrates such excess liquidity,interest income may be offset against interestexpense in looking at overall financial expens-es. Net debt leverage is similarly calculated bynetting out excess liquidity from short-termborrowings. Each situation is analyzed on acase-by-case basis, subject to additional infor-mation regarding a company’s liquidity posi-tion, normal working cash needs, nature ofshort-term borrowings, and funding philoso-phy. Funds earmarked for future use, such asan acquisition or a capital project, are notnetted out.

In some countries it is not uncommon forindustrial companies to establish their treasuryoperations as a profit center. In Japan, forexample, the term “zaiteku financing” refersto the practice of generating profits througharbitrage and other financial-market transac-tions. If financial position-taking comprises amaterial part of a company’s aggregate earn-ings, Standard & Poor’s segregates those earn-ings to assess the profitability of the core busi-ness. Standard & Poor’s may also view withskepticism the ability to realize such profits ona sustained basis and may treat them like non-recurring gains.

Earnings differencesShareholder pressures and accounting stan-

dards in certain countries—such as the U.S.—can result in companies seeking to maximizeprofits on a quarter-to-quarter or short-termbasis. In other regions—aided by local tax reg-



ulation—it is normal practice to take provi-sions against earnings in good times to providea cushion against downturns, resulting in along run “smoothing” of reported profits.Given local accounting standards, it is not rareto see a Swiss or German company vaguelyreport “other income” or “other expenses,”which are largely provisions or provisionreversals, as the largest line items in a profitand loss account. In meetings with manage-ment, Standard & Poor’s discusses provision-ing and depreciation practices to see to whatextent a company employs noncash charges toreduce or bolster earnings. Credit analysisfocuses on operating performance and cashflow, not financial reports distorted byaccounting techniques.

Contingent liabilitiesConsideration of contingent liabilities also

varies internationally. Off-balance-sheet oblig-ations can often be significant and subject todiffering methods of calculation. For example,the practice of factoring receivables withrecourse back to the company is common inJapan. While some accounting systems treatthis practice as a form of debt financing,Japanese companies simply report it as acontingency.

Pensions are handled very differently in dif-ferent countries. For example, U.S. firmsexplicitly reflect the pension asset/liability ontheir balance sheet, while German firms do not.Standard & Poor’s adds in any pension obliga-tion when calculating ratios for German firms,to incorporate a consistent view of these liabil-ities. Other forms of contingent liabilities, suchas implicit financial support to nonconsolidat-ed affiliated companies or projects, are alsocommon, and are factored into the analysis.

Other national and regional factorsMany international corporate issuers benefit

from their status within the country or regionof domicile. This is particularly true for corpo-rates with significant state ownership. Otherlocal factors that might affect an issuer’s finan-cial flexibility include access to local banks andcapital markets.

State ownershipWithout a guarantee or other form of formal

support arrangement, a state-owned corporateissuer does not intrinsically carry the same levelof credit risk as its sovereign owner.

Nevertheless, state ownership can bolster acompany’s credit profile through implicit sup-port. Government support can take the form offacilitated access to external sources of capitalor, in extreme cases, direct financial infusions.

The link between government and industrydiffers from country to country and, evenwithin a country, from firm to firm. The analy-sis begins by considering the state’s historicalrelationship with industry, including the degreeto which governmental financial aid has beenused to support state-owned firms in the past.However, it is important to anticipate potentialchanges in historical arrangements. For exam-ple, Economic Commission competition hasthe potential to inhibit the ability of memberstates to grant economic support freely toindustries operating in competitive sectors. Inmany countries, the trend of late has beentoward forcing government-owned entities tooperate in a more self-sufficient manner—dubbed “corporatization”—and withdrawingstate support.

The analyst considers the strategic impor-tance of the firm to the country of domicile.Certain state-owned firms provide a vital ser-vice or technology, often in fields relating todefense, energy, telecommunications, or elec-tronics. Such firms may be perceived to servenational interests more than firms engaged inmore basic industries. Also considered is afirm’s economic importance—in terms ofemployment, foreign-exchange generation,and local investment. Standard & Poor’smeets with officials of sovereign governmentsto ascertain their view of a firm’s strategicimportance and potential sovereign supportfor that issuer.

Analysis of an issuer on a stand-alone basisallows the rating to reflect both the likelihoodof the issuer needing to seek external state sup-port and the likelihood of receiving such sup-port. Wherever a rating is notably higher thanit would have been on a stand-alone basis,strong implicit ties to the sovereign state havebeen confirmed in meetings with governmentofficials.

Local ownership blocksConcentration of ownership, resulting in

companies with cross shareholdings or com-mon parents, exists in several countries. Japanand Korea, for example, have numerous indus-trial groupings that combine companies acrossseveral industrial sectors. In Canada, Sweden,





Latin America, and Southeast Asia large net-works of family holdings are found.

There are both positive and negative impli-cations of group affiliation. In many cases, acompany may benefit from operating relation-ships or greater access to financing.Conversely, a company’s group affiliationcould bring responsibility for providing sup-port to weaker group companies. Standard &Poor’s assesses whether constraints on groupinfluence, such as an external minority interestposition, justify rating an issuer on a stand-alone basis. If not, the analysis attempts toincorporate the economic and financial trendsin the issuer’s affiliate group as well.

Access to local sources of capitalAn issuer’s standing within its home finan-

cial community is also considered. Large

issuers in a relatively small country are often ina favorable position to attract financing fromthat country’s banking system. Access to readybank financing may be enhanced by crossshareholdings between a bank and an industri-al firm or the development over time of a spe-cial relationship with one or more banks. Atthe same time, certain issuers benefit fromrecognition and status within local capitalmarkets. While access to public debt and equi-ty cannot be assumed, particularly in times offinancial stress, prominence within local mar-kets broadens a firm’s financial options. Oneway to determine how well a company mightcompete for capital is by comparing its perfor-mance to local peers in terms of local account-ing and financial norms.

LOCAL CURRENCY CREDIT RATING:

A current opinion of an obligor’s overallcapacity to generate sufficient local currencyresources to meet its financial obligations(both foreign and local currency), absent therisk of direct sovereign intervention that mayconstrain payment of foreign currency debt.Local currency credit ratings are provided onStandard & Poor’s global scale or on separatedomestic scales, and they may take the formof either issuer or specific issue credit ratings.

Country or economic risk considerations per-tain to the impact of government policies onthe obligor’s business and financial environ-ment, including factors such as the exchangerate, interest rates, inflation, labor market con-ditions, taxation, regulation, and infrastructure.However, the opinion does not address trans-fer and other risks related to direct sovereignintervention to prevent the timely servicing ofcross-border obligations.

FOREIGN CURRENCY CREDIT RATING:

A current opinion of an obligor’s overallcapacity to met its foreign-currency-denomi-nated financial obligations. It may take theform of either an issuer or an issue creditrating. As in the case of local currency creditratings, a foreign currency credit opinion onStandard & Poor’s global scale is based on theobligor’s individual credit characteristics,including the influence of country or economicrisk factors. However, unlike local currency rat-ings, a foreign currency credit rating includestransfer and other risks related to sovereignactions that may directly affect access to theforeign exchange needed for timely servicingof the rated obligation.

Transfer and other direct sovereign risksaddressed in such ratings include the likeli-hood of foreign-exchange controls and theimposition of other restrictions on the repay-ment of foreign debt.

Standard & Poor’s rating criteria has alwaysemphasized an appreciation of relevant localcharacteristics. In emerging markets, countryrisk takes on added importance. Outlinedbelow are examples of various country-specif-ic factors, which pertain to every aspect of cor-porate analysis.

The degree of concern to attribute to localeconomic/political risk factors is a function ofthe likelihood of their occurring. Sovereign rat-ings provide much insight into the perceivedlikelihood of these risks coming into play.

To acheive a local currency corporate ratinghigher than the sovereign foreign currency rat-ing would mean that the corporate can serviceits debts (not just survive as an ongoing con-cern) even under a scenario so severe—in termsof inflation, currency devaluation, and fiscalcrisis—that it causes the government to defaulton its foreign currency debt. And to be higher-

means that the corporate can continue to ser-vice its debt even under a scenario so severe—in terms of financial crisis, banking system col-lapse, political unrest, or even anarchy—that itcauses the government to default on its localcurrency debt.

indeed have managed to honor their obliga-tions even under such stressful circumstances.But these instances are clearly the exception to

(Separately, there is the risk of direct govern-ment intervention—which is particularly ger-mane to foreign currency ratings. That is dis-cussed on page 37.)

Business risk factorsMacroeconomic volatility. Does the coun-

try’s economic track record suggest highvolatility in the macroenvironment? This maycompound the constraint on credit quality typ-ically associated with cyclical industries, sincethey become even more cyclical, and mayexperience stronger “booms” and “busts.”

Access to imported raw materials. Is thecompany heavily dependent on imported sup-plies, and could the company’s operationstherefore be interrupted if foreign-exchangecontrols are imposed by the sovereign?

Exchange-rate risk. Is the exchange rate sub-ject to significant volatility, which could com-press margins relative to global peers and/oraffect demand for products?

Government regulation. Is there a risk of thegovernment “changing the rules of the game,”through import/export restrictions, directintervention in service quality or levels,redefining boundaries of competition such asservice areas, altering existing barriers to entry,changing subsidies, or changing antitrust legis-lation? For extractive industries, what is therisk of government contract renegotiation ornationalization? Are environmental regula-tions expected to tighten significantly; are locallobbying groups gaining political clout in thisrespect?

Taxes/royalties/duties. Does the company orits key investments enjoy tax subsidies or royal-ty arrangements that have renegotiation risk atthe federal or regional level? Does the govern-ment have a history of micro-managing the cur-



Country Risk: Emerging Markets

ed by country factors. Nonetheless, companies

History shows us that some companies

rated than the sovereign local currency rating

And the further away a country is from default

higher than the sovereign, since their risk ofthat mitigate these specific risks can be rated

default may be lower. Even for such companies,there would normally be a limit on how farabove the sovereign the corporate rating

would be. (In the typical case, the com-bination of ordinary corporate risks with thepotential for problems associated with a risky

entity in that country!)

country environment add up to a lower ratingthan the government’s—the most creditworthy

the rule, as all companies are extensively affect-

in advance how things will play out in crises.could go, considering how difficult it is to divine

the more speculative such an undertaking

rent account balance through changing taxes orduties on imports/exports/foreign borrowings?

Legal issues. What is the transparency of thelegal system? Does the type of legal system(common vs. civil vs. Islamic) create differ-ences in contract risks or treatment of creditorrights, particularly with regard to collateraland workout/bankruptcy situations?

Labor issues. What is the potential forstrikes? Is there inflexibility of regulationswhich may make firing workers an unrealisticor expensive option?

Infrastructure problems. Are there potentialbottlenecks, poor transport, high-cost/ineffi-cient port services? Is there a need to supplyown electricity or other basic services/infra-structure?

Changing tariff barriers/trade blocs/subsidies. Are domestic companies protectedby tariffs or other industry subsidies that arelikely to drop as governments liberalize theirexternal trade regulations? Has/will the coun-try join a local trade bloc, which could imme-diately drop tariffs on imports from members?

Corruption issues. Is corruption an issue interms of raising the cost of business or creatinguncertainty about maintaining a “level playingfield” for business?

Terrorism. Are there risks of attacks on thecompanies facilities, kidnapping of keyemployees? How has the company mitigatedthese risks?

Industry structure/operating environment.Industry characteristics may be favorable or

and fragmented U.S. market. Growth prospectsfor consumer products or new technologies andservices can offer tremendous opportunities, bytracking expected population growth or increas-ing per capita incomes, which may be offset byother risks. For example, demand for cellulartelephones in many emerging markets that areunderserved is exploding, yet there are still limi-tations due to relatively low per capita incomesand changing regulations, which may allow newforms of competition.

Financial risk factorsFinancial policy:Disclosure/local accounting standards

issues. Does the company provide consolidatedfinancial statements? The lack of consolidated

statements, which may not be required by localregulatory/accounting standards, can hinderthe analyst’s ability to assess overall cash flowgeneration and debt service coverage. Lack ofsegment information may make it difficult toanalyze properly profitability trends or projectperformance. Changes in overall accountingpresentation, for example eliminating inflationaccounting without requiring restatement ofprior years, makes trend comparisons mean-ingless or difficult. Obtaining timely financialstatement reporting may be an issue.

Foreign-exchange risks. Does the companyhedge foreign-exchange risks, to the extent it iswithin its control to do so? Does the companyshow a propensity to speculate with financialarbitrage opportunities? (For example, doesthe company borrow in U.S. dollars to investin high interest rate local currency instruments,exposing itself to devaluation risk?)

Family/group ownership issues. If the issueris part of a conglomerate or family-controlledgroup of companies, is the company’s financialpolicy dictated by the group, and are therepotential weaknesses at other group compa-nies that could negatively affect the issuer?Conversely, strong group ownership and sup-port can enhance creditworthiness.

Profitability/cash flow:Potential price controls. These are particu-

larly a threat for basic local goods or services,such as telephone/electric services, or gasolinesales. At times of spiraling inflation (a risk cap-tured in the sovereign foreign currency rating),governments often try to assuage consumers

services, and under severe stress may freeze all

Inflation/currency fluctuation risk. Whereexisting or potential high/accelerating infla-tion is an issue, does the company have thepricing flexibility, systems, and know-how tokeep revenues increasing in-line with or aheadof costs? Will import prices of supplies beaffected by devaluation? How well matched,by currency, are revenues and costs? Does amismatch expose the company to devaluationor, for exporters, currency appreciation risk,which can lead to sustained reductions inprofitability?

Restricted access to subsidiary cash flow. Isaccess to cash flows of foreign subsidiariesconstrained by potential transfer/convertibilityrisk?



by controlling prices on highly visible goods orexample, the cement industry in Mexicounfavorable relative to global peers. For

is highly concentrated among two or threelarge players, versus a fiercely competitive prices in an effort to control inflation.



Capital structure/financial flexibility:Inflation accounting. Does local accounting

tend to overstate fixed asset values, whichleads to understated or noncomparable lever-

Devaluation risk. Does the currency of debtobligations expose the company to devalua-

Access to capital. This is often a key con-straint for emerging market issuers, whichbroadly penalizes their credit quality relativeto those of firms in developed markets. Even

issuers have had difficulties accessing local orinternational capital markets during periods of

prevent companies from accessing local mar-kets at reasonable rates as well; at times of

stress, the local banking system would be suf-fering illiquidity due to high capital flight. Aweak or poorly regulated local banking systemcan introduce additional volatility. Moreover,Latin American-based companies typically donot have access to committed credit lines.

Debt maturity structure. For emerging mar-ket issuers, concentration in short-term debt,whether dollar- or local-currency denominat-ed, exposes the company to critical rollover

Local dividend payout requirements. Dothe requirements make dividends more like afixed cost? In Chile, public companies mustpay out a minimum 30% of net income as div-idends, while Brazil has a 25% minimumrequirement. On the other hand, this explicitlink of payments to profits gives companiesmore flexibility to lower dividends when prof-its decrease.

Liquidity restrictions. Is the company’s liq-uid asset position held in local governmentbonds, local banks, or local equities, and willthe issuer have access to these assets at times of

may lead to relatively understated earnings.

age ratios? As a consequence of overstatedfixed asset values, high depreciation charges

tion risk? How well matched by currency arerevenues versus debt? Companies with local

currency revenue stream and dollar- denominated debt see their earnings powerseverely hurt relative to debt service when thegovernment devalues the currency. Whilelocal inflation eventually may allow comp-

market conditions or price controls limit pricethis process generally takes time, as weak local

flexibility.

stress. Thin domestic capital markets

risk.

stress on the sovereign. For example, local

stress scenarios in Ecuador in 1998/1999

anies to raise prices enough to compensate,

bank deposit freezes accompanied the sovereign

and in Argentina in 2002.

the strongest emerging market private-sector

Sovereign credit risk is always a key consid-eration in the assessment of the credit standingof banks and corporates. Sovereign risk comesinto play because the unique, wide-rangingpowers and resources of a national govern-ment affect the financial and operating envi-ronments of entities under its jurisdiction. Pastexperience has shown time and again thatdefaults by otherwise creditworthy borrowerscan stem directly from a sovereign default.

In the case of foreign currency debt, the sov-ereign has first claim on available foreignexchange, and it controls the ability of any res-ident to obtain funds to repay creditors. Toservice debt denominated in local currency, thesovereign can exercise its powers to tax, tocontrol the domestic financial system, andeven to issue local currency in potentiallyunlimited amounts. Given these considera-tions, the credit ratings of nonsovereign bor-rowers most often are at, or below, the ratingsof the relevant sovereign.

While “sovereign ceiling” is an inappropriateterm, Standard & Poor’s always assesses theimpact of sovereign risk on the creditworthinessof each issuer and how it may affect the abilityof that issuer to fulfill its obligations accordingto the terms of a particular debt instrument. Thisis done in a more flexible manner than the term“ceiling” suggests, by looking at the issuer’s ownposition and ability to meet its obligations ingeneral, as well as the particular features of aspecific obligation that might affect its timelypayment. For example, geographic diversifica-tion or support by an external parent tends toadd to the overall creditworthiness of a borrow-er and to lessen its exposure to sovereign action.Also, borrowers may add features to specificdebt issues, such as external guarantees, or theymay structure them in particular ways, such asasset-backed transactions, that enhance the like-lihood of payment. Nevertheless, for most inter-national debt issuers, the sovereign risk factorremains an extremely important consideration inthe assignment of overall creditworthiness.

From 1975-1995, Standard & Poor’s hasdocumented 69 cases of sovereign default oneither bond or bank debt. Of those defaultingcountries where there was significant private-sector external debt outstanding at the time,private-sector borrowers defaulted in 68% ofthe cases.

The key elements to consider are: • The economic, business, and social envi-ronments that influence both the sovereign’sown rating and those of issuers domiciledthere. (Refer to previous section.) • The ways in which a sovereign can direct-ly or indirectly intervene to affect the abilityof an entity to meet its offshore debt obliga-tions, even if that entity has sufficient fundson hand to meet that obligation.

Actions by the sovereignSovereign governments in many countries

act to constrain an issuer’s ability to meet off-shore debt obligations in a timely manner.While higher-rated sovereigns are not expectedto interfere with the issuer’s ability to use avail-able funds to meet such offshore obligations,the chances of some form of interventionincrease significantly for entities domiciled inlower-rated nations.

At a time of local economic stress, when for-eign exchange is viewed as an increasinglyscarce and valuable commodity, the likelihoodof direct constraint, intervention, or interferencewith access to foreign exchange can be high. Forthis reason alone, it is unlikely that most issuers’ability to meet offshore debt obligations in atimely manner can be viewed as more probablethan their sovereign’s own likelihood of meetingtheir offshore debt obligations.

Even when the issuer has sufficient funds tomeet its offshore debt obligations, the sover-

constrain, the issuer from meeting those oblig-



Sovereign Risk

ations in a timely manner. Such constraint can

eign may absolutely prohibit, or otherwise

take many forms. During 2002, for example,the Argentinean government rationed

the availability of foreign exchange to private-sector entities to the point that some of theseentities defaulted on foreign currency debtobligations, despite many of these same firmshaving sufficient funds to meet these obliga-tions in a timely manner if access to foreignexchange had been possible.

However, sovereign governments do notnecessarily treat all types of debt obligationsequally. In the past, even in situations wherethe sovereign itself was in default on some ofits debt, permission has been granted for cer-tain obligations to be met on a timely basis.Trade credits are often distinguished from cap-ital market instruments. In several instances inthe 1980s, bond debt issued by private LatinAmerican entities continued to be servicedeven while bank loans were being rescheduled,although at that time bond debt was relativelylow. With bond debt increasing as a propor-tion of the total, future situations could bequite different. Standard & Poor’s expects thatsovereigns will continue to discriminate amongthe wide range of issues in the future, permit-ting some to proceed while constraining oth-ers. Therefore, each obligation must be ana-lyzed on its own merits in the rating processand the likely government action with respectto that type of obligation addressed.

A sovereign government under severe eco-nomic or financial pressure seeking to retainvalued foreign currency reserves in the country,and which may not be able to meet, or alreadyhas not met, its timely obligations on offshoredebt, could impose many constraints on othergovernmental or private-sector borrowers,including:

• Setting limits on the absolute availabilityto foreign exchange; • Maintaining dual or multiple exchangerates for different types of transactions;• Making it illegal to maintain offshore orforeign currency bank accounts;• Requiring the repatriation of all funds heldabroad, or the immediate repatriation ofproceeds from exports and conversion tolocal currency;• Seizing physical or financial assets if for-eign-exchange regulations are breached;• Requiring that all exports (of the goods inquestion) be conducted through a central-

ized marketing authority, or the posting of asignificant bond prior to the export of goodsto assure immediate repatriation ofproceeds;• Implementing restrictions on inward andoutward capital movements;• Refusing to clear a transfer of funds fromone entity to another;• Revoking permission to use funds to repaydebt obligations;• Mandating a moratorium on interest andprincipal payments, or required reschedulingor restructuring of debt; and• “Nationalizing” the debt of an issuer andmaking it subject to the same repaymentterms or debt restructuring as that of thesovereign.The past record of a particular sovereign can

indicate the potential for imposition of con-trols in the future. Some sovereigns have dis-played much more restraint in applying con-trols to private capital movements than others,and such a positive track record is incorporat-ed into the assessment of both the sovereignitself and entities domiciled in that country. Inaddition, different types of obligations mayhave been treated differently. However, a goodtrack record is not, in and of itself, definitiveproof that the sovereign would not imposecontrols of some type at some point in thefuture in a period of severe economic stress.Conditions change and governments change.

One key element in this evaluation iswhether, and to what degree, a particulartransaction fits within the national priorities.For example, when a government is activelyencouraging exports, a transaction specificallytied to export promotion might be favored andremain exempt from restrictions even whileother transactions, which do not fulfill suchnational objectives, are constrained. In addi-tion, when specific permission for a transac-tion has been granted, a sovereign might bemore reluctant to withdraw such permission,or may “grandfather” that particular transac-tion, while future transactions are constrainedor prohibited. It is therefore possible that somedebt issues of a particular borrower are nothighly subject to sovereign interference, whileothers issued by the same entity are.





Government ownership andregulation

Many of the entities issuing debt that aredomiciled in low-rated countries are partially,or completely, government owned. If foreign-exchange controls are imposed, it is unlikelythat government-owned institutions would bepermitted or would choose to circumvent gov-ernment controls.

The same holds true for entities that arehighly regulated by the government, even with-out a direct ownership tie. This includes mostfinancial institutions and regulated utilities.Thus, it is unlikely that a government-ownedentity, or one that is highly regulated, could beviewed as more creditworthy than the sover-eign itself in terms of meeting foreign currencyobligations.

Duration of controlsWhen controls or restrictions are imposed,

their duration cannot be predicted. In someinstances, controls have lasted for only a fewweeks or months, and in some others, theyhave been applied selectively. In still othercases, they have been much longer-lasting andall-encompassing. A rating cannot be based ona guess as to the duration or comprehensive-ness of controls, and analysis cannot determinethat controls would be in place for a specific(short) period of time. Accordingly, liquidityand parental support which would only tem-porarily serve to meet debt service are not suf-ficient to justify a higher rating in themselves.

may be used for some transactions—to cover

export receivables deal, for example—but notto deal with the potential imposition of cur-rency controls or similar actions that may pre-vent the payment on debt.

Governing lawThe law governing a specific debt issue, as

well as other legal factors, may be relevant inevaluating whether a sovereign could affecttimely payment on a debt obligation. However,Standard & Poor’s exercises caution in placingweight on the legal factor. When sovereignpowers are involved, issues such as conflicts oflaw, waivers, and permission to hold and usefunds held outside the country of domicile areconfused at best and would likely be tested andresolved by the courts only after, rather thanprior to, a default.

Special casesIn some instances, an issuer is technically

domiciled in a particular country for tax orreasons other than business undertaken withinthat country. For example, issuers domiciled incertain specified financial centers, such as theCayman Islands, are viewed as independent ofthat financial center’s sovereign risk. No sub-stantial business is undertaken within thatjurisdiction; no substantive assets are main-tained in that jurisdiction; and the issuer couldchange its location quickly and without risk tothe debtholder should the sovereign imposeany form of controls or onerous taxes.

Multilateral lending institutions, such as theInternational Bank for Reconstruction andDevelopment (World Bank), the InternationalFinance Corporation (IFC), and theInteramerican Development Bank (IADB),enjoy preferred creditor status. By virtue of theborrowing country’s membership in the lend-ing organization and as a condition of eligibil-ity to receive loans, the country assures that itwill not impose any currency restriction orother impairment to the repayment of suchloans. In some cases, the treaty establishing theorganization also specifies such special treat-ment of loans by member nations. Often theseloans, while made to other, nonsovereign enti-

the temporary interruption of supply for an

overcome the impact of controls. Reserve fundseven longer cannot be assumed sufficient toA reserve fund of one year’s payments or

ties, are also guaranteed by the borrowingcountry, and the lending institution has a poli-cy that no further loans will be granted to bor-rowers in that country if any loans are indefault.

These factors give the borrowing countrystrong incentives to maintain timely loanrepayment. The result has been an excellentrepayment record for such obligations even

while other borrowings from banks or otherlenders have fallen into default. One analyticalelement is assessing the creditworthiness ofthese loans in the proportion of a country’stotal external indebtedness made up of thistype of obligation. The larger the proportion,the more difficult it may be for the country tomeet these in a timely manner and preservetheir special status.



Standard & Poor’s credit ratings are meant tobe forward-looking; that is, their time horizonextends as far as is analytically foreseeable.Accordingly, the anticipated ups and downs ofbusiness cycles—whether industry-specific orrelated to the general economy—should be fac-tored into the credit rating all along. Thisapproach is in keeping with Standard & Poor’sbelief that the value of its rating products isgreatest when its ratings focus on the long term,and do not fluctuate with near-term perfor-mance. Ratings should never be a mere snapshotof the present situation. There are two modelsfor how cyclicality is incorporated in credit rat-ings. Sometimes, ratings are held constantthroughout the cycle. Alternatively, the ratingdoes vary—but within a relatively narrow band.

Cyclicality and business riskCyclicality is, of course, a negative that is

incorporated in the assessment of a firm’s busi-ness risk. The degree of business risk, in turn,becomes the basis for establishing ratio stan-dards for a given company for a given ratingcategory. (The ratio guidelines that Standard &Poor’s publishes are expressed as a matrix, sothat the degree of business risk is explicitly rec-ognized.) The analysis then focuses on a firm’sability to meet these levels, on average, over afull business cycle, and the extent to which itmay deviate and for how long.

The ideal is to rate “through the cycle” (seechart 1). There is no point in assigning high

ratings to a company enjoying peak prosperityif that performance level is expected to be onlytemporary. Similarly, there is no need to lowerratings to reflect poor performance as long asone can reliably anticipate that better times arejust around the corner.

The rating profile of the chemical industryoffers a good illustration of Standard & Poor’slong-term approach. Ratings for the majorindustry participants have been highly stableover a 12-year period, which has included twofull industry cycles.

However, rating through the cycle is oftenthe incorrect model. One reason is that ratingthrough the cycle requires an ability to predictthe cyclical pattern—and this is usually diffi-cult to do. If indeed there is such a thing as a“normal” cycle, it is rare. The phases of thelatest cycle will probably be longer or shorter,steeper or less severe, than just repetitions ofearlier cycles. Management’s determination tolearn from previous cycles itself implies that“things will be different this time.” Interactionof cycles from different parts of the globe, andthe convergence of secular and cyclical forcesfurther complicate things.

Moreover, even predictable cycles can affectindividual firms so as to have a lasting impacton credit quality. For example, a firm mayaccumulate enough cash in the upturn to miti-gate the risks of the next downturn. (The BigThree automobile manufacturers have beenable—during the most recent cyclicalupswing—to accumulate huge cash hoardsthat should exceed cash outflows anticipatedin future recessions.) Conversely, a firm’s busi-ness can be so impaired during a downturnthat its competitive position may be perma-nently altered. In the extreme, a company willnot survive a cyclical downturn to participatein the upturn!

Accordingly, ratings may well be adjustedwith the phases of a cycle. Normally, however,the range of the ratings would not fully mirrorthe amplitude of the company’s cyclical highs



Factoring Cyclicality into Corporate Ratings

Chart 1

Time

Corporateperformance

Standard & Poor'sRating

AA

A

BBB



or lows, given the expectation that a cyclicalpattern will persist. The expectation of changefrom the current performance level—for betteror worse—would temper any rating action,even absent a totally clear picture of the cycli-cal pattern. In most cases, then, the typicalrelationship of ratings and cycles might lookmore like chart 2.

The ratings of the forest products industryreflect such a pattern.

Sensitivity to cyclical factors—and ratingsstability—also varies considerably along therating spectrum. The creditworthiness of non-investment-grade firms is, almost by definition,more volatile. Moreover, the lowest credit rat-ing categories often connote the imminence ofdefault. As the credit quality of a company isincreasingly marginal, the nature and timing ofnear-term changes in market conditions couldmean the difference between survival and fail-ure. A cyclical downturn may involve the threatof default before the opportunity to participatein the upturn that may follow. Accordingly,cyclical fluctuations will usually lead directly torating changes—possibly even several ratingchanges in a relatively short period. Conversely,a cyclical upturn may give companies abreather that may warrant a modest upgrade ortwo from those very low levels.

In contrast, companies viewed as havingstrong fundamentals—that is, those enjoyinginvestment-grade ratings—are unlikely to seetheir ratings changed significantly due to fac-tors deemed to be purely cyclical—unless thecycle is either substantially different from whatwas anticipated or the company’s performanceis somehow exceptional relative to what hadbeen expected.

Analytical challengesThe notion of “rating through the cycle,”

while conceptually appealing, presupposes

that the characteristics of future cycles arereadily foreseeable. The very term “cycle”seems to imply regularity. In actuality, this isseldom the case.

Cyclicality encompasses several differentphenomena that can affect a company’s per-formance. General business cycles, marked byfluctuations in overall economic activity anddemand, are only one type. Demand-drivencycles may be specific to a particular industry.For example, product-replacement cycles leadto volatile swings in demand for semiconduc-tors. Other types of cycles arise from varia-tions in supply, as seen in the pattern of capac-ity expansion and retrenchment that is charac-teristic of the chemicals, forest products, andmetals sectors. In some cases, natural phenom-ena are the driving forces behind swings insupply. For example, variations in weatherconditions result in periods of shortage or sur-plus in agricultural commodities.

The confluence of different types of cycles isnot unusual. For example, a general cyclicalupturn could coincide with an industry’s con-struction cycle that has been spurred by newtechnology. The interrelationship of differentnational economies is an additional complicat-ing factor.

All these cycles can vary considerably intheir duration, magnitude, and dynamics. Forexample, the unprecedented eight years ofuninterrupted, robust economic expansion inthe U.S. that followed the 1982 trough wastotally unforeseen. On the other hand, therewas no basis to assume in advance that thedownturn that followed would be so severe,albeit relatively brief. Indeed, at any givenpoint, it is difficult to know the stage in thecycle of the general economy, or a given indus-trial sector. A “plateau” following a period ofdemand growth might indicate that the peakhas been reached—or it could represent apause before the resumption of growth.

Even general downturns vary in theirdynamics, affecting industry sectors different-ly. For example, the soaring interest rates thataccompanied the recession of 1980-1981 had aparticularly adverse affect on sales of con-sumer durables, such as automobiles.Sometimes, sluggish demand for large-ticketitems can spur demand for other, less costlyconsumer products.

In any case, purely cyclical factors are diffi-cult to differentiate from coincident secularchanges in industry fundamentals, such as the

Chart 2

Time

Corporateperformance

Standard & Poor'sRating

AA

A

BBB

emergence of new competitors, changes intechnology, or shifts in customer preferences.Similarly, it may be tempting to view cyclicalbenefits—such as good capacity utilization—as a secular improvement in an industry’scompetitive dynamics.

A high degree of rating stability for a com-pany throughout the cycle also should entailconsistency in business strategy and financialpolicy. In reality, management psychology isoften strongly influenced by the course of acycle. For example, in the midst of a pro-longed, highly favorable cyclical rebound, agiven management’s resolve to pursue a con-servative growth strategy and financial policymay be weakened. Shifts in managementpsychology may affect not just individual

companies, but entire industries. Favorablemarket conditions may spur industry-wideacquisition activity or capacity expansion.

Standard & Poor’s is also cognizant thatpublic sentiment about cyclical credits mayfluctuate between extremes over the course ofthe cycle, with important ramifications forfinancial flexibility. Whatever Standard &Poor’s own views about the long-term stayingpower of a given company, the degree of pub-lic confidence in the company’s financial via-bility is critical for it to have access to capitalmarkets, bank credit, and even trade credit.Accordingly, the psychology and the percep-tions of capital providers must be taken intoaccount.



The regulatory relationship can be a benignone—or it can be adversarial. It affects virtual-ly all corporates to one extent or another, andis obviously critical in the case of utilities—where it is a factor in all assessments ofbusiness risk.

Evaluation of governmental involvement/regulation encompasses legislative, administra-tive, and judicial processes at the local andnational levels. This evaluation considers thecurrent environment—and the potential forchange. For example, a system that requireslegislative action to modify regulations is morestable—and is viewed more positively—thanone that is subject to ministerial whim, asexists in some Asian countries. Similarly, a reg-ulatory framework enacted with regard to arecently privatized system is more prone to berevisited by government regulators.

The impact of regulation runs the gamut—from regulation’s providing of direct, tangiblesupport to its being a hindrance. For a utilitybusiness profile to be considered “well aboveaverage” usually requires strong evidence ofgovernment support or regulatory sheltering.Support can be explicit—such as in Canada andin other locales where a government guaranteesa utility’s obligations. Or it can take the form ofstrong and obvious implicit support, such as inGreece.

Japanese investor-owned utilities have his-torically been insulated from competition andbeen protected by a very cooperative, coordi-nated, rate-setting process. Other governmentsmay facilitate the utility’s access to externalsources of capital, especially where the utilityis a direct instrument of government policy. Inthe U.S., municipally owned utilities have alsobeen sheltered—at least they have in the past.(Deregulation has unleashed competitive pres-sures, but politics makes it difficult to makeadjustments that would affect either residentialrates or the city’s own general fund.)

Short of such outright support, regulatorytreatment should be transparent and timely

and should allow for consistent performance—if it is to be viewed positively in the ratingscontext.

Aspects of RegulationThe role of the regulator is evident in: • Rate setting,• Operational oversight, and• Financial oversight.Setting rates is obviously important. To sup-

port credit quality, a utility must be assured ofearning a fair—and consistent—rate of return.Different regulators can be more—or less—generous with respect to the levels allowed —or with respect to which assets are included inthe “returns” calculations. They can choose tooverlook—or to penalize—a utility for anyservice shortcomings in service.

Operational regulation pertains to technolo-gy, to environmental protection considera-tions, safety rules, facility siting, and servicelevels—and the freedom a company has to pur-sue initiatives involving each of these areas.Regulatory inflexibility can hamstring the util-ity in its attempt to be competitive. For exam-ple, if a utility faces new competition for itslarge users, it may want to lower the rates itcharges its commercial/industrial customers—and make up its lost revenues by raising therates at the expense of residential customers.The regulators may object and insist that resi-dential rates continue to be subsidized—creat-ing a problem for the company.

Financial oversight refers to the regulator’sability to maintain—and interest in maintain-ing—a particular level of credit quality at theutility. This is a separate consideration fromhow benign the relationship might be in otherrespects. If the situation warrants it, the ratingevaluation may rely on the regulator toenforce—or at least encourage—a certain levelof financial strength at the utility. In thisrespect, the regulator’s role can take differentforms:



Regulation

• Approval is the most basic element. That autility requires approval to sell debt or paydividends creates an obstacle with respect toits fiscal aggressiveness. • Influence refers to the economic incentivesthat a regulator can provide to maintain acertain level of credit quality. In jurisdictionswith rate-of-return regulation, regulators caneffectively mandate their view of an “appro-priate” balance sheet by specifying return onequity. Even when regulation is not classic“rate base rate of return”—such as withprice cap or banded rate of return—regula-tors may still desire a minimum level of cred-it quality. In past Standard & Poor’s surveys,regulators articulated a concern about creditquality’s falling below ‘A’. Now, however,attitudes are changing about regulating withan eye toward credit quality.• Regulatory mandate—the explicit demandof a specified level of credit quality—is raretoday. In the past, some regulators wouldimpose penalties if a company’s credit ratingdropped below the desired minimum.As competition intensifies, regulators have

focused on service quality, and are less con-cerned with credit quality. (After all, even abankrupt utility can continue to deliver ser-vices!) Of course, not all regulatory jurisdic-tions will follow the trend in identical fashion.In the U.S., there are currently few instanceswhere ratings rely heavily on regulators tomaintain credit quality; outside the U.S., how-ever, there is a greater basis for depending onregulators in this regard.

Regulatory SeparationUtilities are often owned by companies that

own other, riskier businesses or that that aresaddled with an additional layer of debt at theparent level. Corporate rating criteria wouldrarely view the default risk of an unregulatedsubsidiary as being substantially different fromthe credit quality of the consolidated economicentity (which would fully take into accountparent-company obligations). Regulated sub-sidiaries can be treated as exceptions to thisrule—if the specific regulators involved areexpected to create barriers that insulate a sub-sidiary from its parent.

In those cases that benefit from regulatoryinsulation, the rating on the subsidiary is morereflective of its “stand-alone” credit profile.(As a corollary, the parent-company rating is

negatively affected—since it is deprived of fullaccess to the subsidiary’s assets and cash flow.)With utilities’ competition and consolidationincreasing and with shifts to new forms of reg-ulation that are coming into existence, howev-er, there is less reason to expect such regulato-ry intervention. Just as there is less and lessbasis to rely generally on regulators to main-tain a level of credit quality—as discussedabove—so, too, there is less basis for regulato-ry separation.

Rating policy has evolved in tandem withthese trends. The bar has been raised withrespect to factoring in expectations that regu-lators would interfere with transactions thatwould impair credit quality. To achieve a rat-ing differential for the subsidiary requires ahigher standard of evidence that such interven-tion would be forthcoming. (See sidebar“Telecommunications Ratings PolicyRevised.”)

In the past, the mere existence of regulationwas given considerable weight when determin-ing the adequacy of protection for the sub-sidiary’s assets and cash flow. Now Standard& Poor’s analyzes regulatory insulation on acase-by-case basis. The key is a regulator’sdemonstrated willingness to protect creditwor-thiness. Some examples of U.S. state jurisdic-tions where protective measures have beenimplemented are Oregon, New York, Virginia,and California.

The Oregon Public Utilities Commissionapproved the Enron Corp./Portland GeneralElectric Co. merger, based on various restric-tive conditions. Likewise, the New York PublicService Commission, in approving the KeyspanEnergy/Long Island Lighting Co. merger,required a cap on leverage, a prohibition ofcertain types of loans, and a limit on holding-company investment in nonutility operations.

Outside the U.S., regulators in many coun-tries still play a more significant role in thefinances of utilities—making the case for reg-ulatory separation in those countries.Moreover, some recent transactions—notablyin the U.K.—have employed (or at least haveconsidered employing) structural insulationtechniques to achieve “ring-fencing” for theacquired utility subsidiary. In these instances,setting up independent directors, minorityownership stakes, and so forth combine withregulatory oversight to insulate the subsidiaryand achieve higher ratings.


� STANDARD & POOR’S� STANDARD & POOR’S



Standard & Poor’s no longer allows the cor-porate credit rating (CCR) of a regulated tele-phone operating company to be higher thanthe CCR of its parent.

The revised approach represents a furtherevolution of the rating methodology for U.S.local exchange companies (LECs) that reflectsthe important regulatory and business devel-opments that have occurred in the telephoneindustry recently. The impact of the policy, oncompanies for which the former regulatoryseparation methodology was applicable, ingeneral, is a lowering of telephone operatingcompany CCRs and a raising of parentcompany CCRs.

Regulatory separation is the factor thathistorically enabled telephone operating com-panies to have higher debt ratings than theirparent companies. (In contrast, for nonutilitycorporates, subsidiary debt ratings have, allalong, been constrained by the rating of theparent.) This constraint is based on the con-cept that, although a subsidiary may—on astand-alone basis—appear to be a bettercredit than its parent, the financially less-cred-itworthy parent ultimately controls the sub-sidiary’s financial actions and so can availitself of the financial resources of the sub-sidiary. Under Standard & Poor’s regulatoryseparation methodology, LECs were deemed tobenefit from a buffer between the LEC sub-sidiary and its parent—that buffer arising fromthe ability and willingness of state regulatorsto impose some level of credit quality at theregulated subsidiary.

In April 1997, following a review of the sta-tus and impact of regulatory separation,Standard & Poor’s modified its criteria regard-ing the application of regulatory separation andthe impact on ratings of U.S. telephone parentcompanies and their LEC subsidiaries. The 1997policy revision acknowledged the continued,but generally decreasing, impact of regulatoryseparation on ratings and led to modifiedguidelines for assessing the ratings impact ofregulatory separation. These guidelines reflect-

ed Standard & Poor’s assessment that therewas sufficient evidence that specific state reg-ulators could and would use their regulatoryrole to ensure maintenance of some minimumcredit quality. As a result of that methodologyrevision, there were a number of ratingchanges that narrowed the rating gap betweenhigher-rated telephone operating subsidiariesand their respective parents.

The new methodology that Standard &Poor’s now uses recognizes the vast industrychanges that have occurred in the three yearssince the Telecommunications Act of 1996,amounting to a secular transformation of thetelecommunications’ competitive environment,and tangible evidence of regulators’ lack ofresponse to credit-weakening events.

Of LECs and CLECsIn general, although LECs still maintain very

favorable market positions, the days of the LECmonopoly are clearly numbered. Driven by theregulatory changes resulting from theTelecommunications Act of 1996 and fast-moving technological developments, competi-tive local exchange companies (CLECs) arebecoming formidable competitors to the LECs.In addition to the vast number of CLECs enter-ing the market for both voice and data, AT&TCorp. is poised to be a major alternative tele-phone provider. AT&T’s goal is not just to bethe largest cable provider, but to modify thewires of its owned and affiliated cable sys-tems to offer local telephone service to mil-lions of potential customers. This multibillion-dollar investment in cable upgrades, if suc-cessful, would make AT&T the largest CLEC,putting it in direct competition with its formerregional Bell operating company affiliates.

The growth of CLECs and the potential forlower-cost wireless service as a wirelinereplacement portend genuine competition formost regulated LECs. This more competitiveenvironment will erode the historical notionthat the LEC was a bottleneck monopoly of avital service. It was this view of the LEC as a

TELECOMMUNICATIONS RATINGS POLICY REVISED



monopoly of a vital public service that led tothe regulatory view that such companiesshould exhibit a pristine balance sheet.Accordingly, state regulators are likely to shifttheir regulatory focus away from oversight of acompany’s financial policy and toward ensur-ing an open marketplace. Specifically,Standard & Poor’s anticipates that regulatorswill increase efforts to ensure that competitorsto the LECs have the necessary tools, includingcollocation and the ability to purchase theexisting network elements, to mount a chal-lenge to the entrenched LEC. This expectedshift in the regulatory paradigm means thatstate regulators will be increasingly less likelyto provide a financial buffer between the telephone operating company and its parent.Protection that formerly inured to bondholdersof the telephone operating company willdissipate.

In addition to the technical and regulatorytrends noted above, there is also tangible evi-dence that the notion of bondholder protectionfrom regulatory separation is becoming obso-lete. During the past couple of years, regula-tors have had the opportunity to react to merg-er proposals that weakened the credit qualityof the regulated company. In fact, the regulato-ry response has generally been focused onopen market and service quality issues, andhas not been focused on the issue of diminu-tion of the regulated operating companies’credit quality.

Recent Industry ActionsWhen Global Crossing Ltd. announced its

ambition to purchase Frontier Telephone ofRochester Inc. (Frontier), Standard & Poor’sindicated that the Frontier ratings could fallsignificantly. Indeed, the Frontier CCR waseventually lowered to ‘BB+’ from ‘AA-’ as aresult of the Global Crossing transaction.Although, because of an earlier agreementwith the New York State Public Service

Commission (PSC), the rating downgrade willrestrict dividends from Frontier for a period oftime, importantly, the PSC did not try to pre-vent the acquisition.

Similarly, Standard & Poor’s lowered its CCR on Cincinnati Bell Telephone Co. (CBT) to‘BBB-’ from ‘AA-’ following parent companyCincinnati Bell Inc.’s (doing business asBroadWing Inc.) acquisition of ‘B’-rated IXCCommunications Inc. This acquisition wasdependent on obtaining Ohio Public UtilitiesCommission (PUCO) approval prior to debtissuances at CBT, thereby limiting the parentcompany’s ability to leverage the telephoneoperating company. However, despite thecredit pressures placed on CBT by its parent’sproposed purchase of the much lower ratedIXC, PUCO did not create any roadblocks forconsummation of the transaction or imposeany financial penalty on CBT for a weakercredit profile.

In June 1999, US West CommunicationsInc., rated ‘A+’, announced it would beacquired by Qwest CommunicationsInternational Inc. Standard & Poor’s noted thatthe CCR of the combined entity could fall aslow as ‘BBB-’. The thrust of regulatory concern:areas of service quality, ensuring access bycompetitors to the US West network, andinteroperability of operating systems betweenUS West and competitors. The issue of lowercredit quality at US West, at this juncture,does not appear to be a hurdle factor in gain-ing regulatory approval.

Standard & Poor’s believes that the preced-ing examples of regulatory responses aresupportive of its revised telephone ratingmethodology that recognizes a new regulatoryand competitive paradigm. Telephone compa-nies can expect to deal with an array ofincreasingly formidable competitors, and tele-phone company bondholders can no longerlook to state regulators for protection.

TELECOMMUNICATIONS RATINGS POLICY REVISED (CONTINUED)

Rationale for CovenantsCovenants provide a framework that lenders

can use to reach an understanding with a bor-rower regarding how the borrower will con-duct its business and financial affairs. Thestronger the covenant package is, the greaterthe degree of control the lender can exerciseover the investment. Borrowers typically seekthe least restrictive covenant package they cannegotiate, since they want maximum flexibilityto conduct their business in the way they see fit.

Covenants’ intended functions include:• Preservation of repayment capacity. Some

covenants limit new borrowings and assurelenders that cash generated both from ongoingoperations and from asset sales will not bediverted from servicing debt. Covenants canprevent shareholder enrichment at the expenseof creditors. Credit quality is preserved byshare-repurchase and dividend restrictions,which seek to maintain funds available fordebt service. Finally, to ensure that the base ofearning assets is maintained, covenants cangovern asset sales and investment decisions.

• Protection against financial restructurings.All lenders are concerned with the risk of asudden deterioration in credit quality that canresult from a takeover, a recapitalization, or asimilar restructuring. Properly craftedcovenants may prevent some of these credit-damaging events from occurring without the

first having been adjusted.• Protection in the event of bankruptcy or

default. These covenants preserve the value ofassets for all creditors and—what is particular-ly important—safeguard the priority positionsof particular lenders. Such covenants assure thelenders that subsequent events or actions willnot materially affect their ultimate recourse.Protection is provided through negative-pledgeclauses, cross-acceleration (or cross-default)provisions, and limits on obligations that eitherare more senior or rank equally.

• Signals and triggers. Signals and triggersassure the steady flow of information, provideearly warning signals of credit deterioration,and place the lender in a position of influenceshould deterioration occur. Since triggers canbring the parties to the table, to enable thelender to decide whether it might be appropri-ate to modify or waive restrictions, they musttherefore be set at appropriate levels, to signaldeterioration before the credit drops to unac-ceptable levels. Among tests that perform thisfunction are net-worth maintenance tests,cross-default provisions, and merger and con-solidation restrictions.

In many cases, covenants can serve morethan one function. For example, a well-writtendebt test will not only help preserve repaymentcapacity, but will also serve as a signal ofpotential credit deterioration and provide pro-tection against damaging recapitalizations.

Public-market participants long ago stoppeddemanding significant covenant protection,perhaps because poorly written covenantpackages with weak tests and significant loop-holes enabled managements to circumventthem. Furthermore, in a widely held transac-tion, a covenant violation that normally wouldbe waived could deteriorate into a paymentdefault, due to the difficulty of having all theinvestors act in unison. Moreover, investors inpublicly traded debt instruments have littleinterest in working with borrowers and proba-bly have fewer resources to do so. Their pri-mary protection is their ability to sell theirinvestments if things should turn sour.

Traditional private-placement investors andbank lenders do have the resources and theexpertise to work out problem credits. Suchinvestors negotiate covenant packages careful-ly, to give themselves the most advantageousposition from which to exercise control, andthey expect to be compensated adequately foraccepting covenants that are weak, those thatmight allow management more leeway tocause a deterioration in credit quality.



Loan Covenants

debt’s first having been repaid or the pricing’s



In general, covenant packages are morerelaxed than in the past, however, because,now, liquidity has increased, and financialmarkets broadened.

Covenants and RatingsCovenants do not play a significant enhanc-

ing role in determining the credit ratingsassigned to companies. In assigning ratings,there are several flaws in a strategy of relyingon covenants to protect credit quality:

• Covenants don’t address fundamentalcredit strength. Covenants do not and cannotaffect the borrower’s facing business adversity,competitive reverses, and so forth. The level ofa covenant is often inconsistent with the ratinglevel desired. For example, a covenant thatallows a company to leverage itself no more

mum leverage tolerated for that specific

• Enforcement is dubious. A company that isdetermined to do so can often, with the assis-tance of its lawyers, find ways to evade the let-ter of the agreement embodied in covenants.They could even choose to ignore them alto-gether! A court will usually not force a com-pany to comply with covenants. Rather, thecourt will award damages—if the breach ofcovenants is considered the cause of the dam-ages. So long as the company continues to payprincipal and interest, the court is unlikely torecognize any damages as having occurred.Enforcement is more likely if there is a specificremedy that is provided for in the event of abreach of the covenant. Usually, the remedy isthe ability to declare an event of default andaccelerate the loan. However, this remedy is sosevere that, more often than not, lenderschoose not to precipitate a default by demand-ing immediate repayment—despite a stipulatedright to do so. Instead, the lender may prefer totake a security position, to raise rates, or toprovide more input into the company’s deci-sions. Such actions could be valuable to thatlender—without enhancing credit quality forthe benefit of all creditors. In practice, lendersalso waive covenants for a variety of reasons.Waivers might result from company/bank rela-tionship issues, a lack of understanding of themagnitude of problems, or a realization thatthe original levels were unnecessarily tight.

• Finally, if the covenants appear only in cer-tain issues, those issues could be refinanced.

For all these reasons, in most cases, Standard

covenant or group of covenants can improve arating. Generally, there is no point in analyzingfine variations among different covenant pack-ages, which certainly will not affect a particu-lar borrower’s ability to meet its obligations ina timely fashion.

Relying on covenants to insulate a sub-sidiary from its parent company is similarlyproblematic. Accordingly, Standards & Poor’swould usually not rate a subsidiary based on

were significant covenant restrictions. The main reason to be aware of a rated enti-

ty's covenants is quite the opposite: Tightcovenants could imperil credit quality by, in theevent of their violation, provoking a crisis withthe lenders, since the lender would have the dis-cretion to accelerate the debt, causing a defaultthat might otherwise have been avoided.

A covenant package can be helpful as anexpression of management’s intent. Since mostcompanies (especially public companies)would be expected to honor, not evade, com-mitments they make, covenants can provide aninsight into management’s plans. An analystwould consider how complying with

ed strategic goals. Management’s willingness

ally been highly leveraged but planned todeleverage in the future, the analyst wouldexpect to see a debt test that ratcheted downover time.

Typical CovenantsCovenants typically vary according to the

level of credit quality. They increase in numberand grow more stringent as the quality of thecredit declines. They also vary depending onwhether the debt is issued publicly or private-ly. Private lenders tend to require a completeand exacting package. These lenders are alsolikely to negotiate—and are more capable ofrenegotiating—covenants in the event of achange in strategy or of a covenant default. Inaddition, the tenor of the loan will governwhich specific covenants are appropriate.

There are certain basic covenants that arepresent in all loan documents, irrespective ofcredit quality or type of financing. While thesecovenants may be worded in different ways,

than 60% has little bearing on the company’s

company as a ‘BBB’.

achieving a ‘BBB’ rating, if 40% is the maxi-

its strong “stand-alone” profile, even if there

& Poor’s does not believe that a particular

to agree to certain restrictive covenants, inessence, “puts their money where their mouth

covenants were consistent with other articulat-

is.” For example, if a company had tradition-

they are considered important by all creditorsfor purposes of managing their investments.They are:

• Information requirements (which financialand other information must be provided atwhich times);• Default (which events might constitutedefaults and which remedies might be pro-vided, possibly including cross-default andcross-acceleration provisions); and • Modifications (how and under which con-ditions the loan documents might be amend-ed, including defeasance provisions, if any).Beyond these provisions, covenants are

transaction-specific. While investment-gradetransactions have few negative covenants,there are some that are common, including:

• A limitation on liens (with a negativepledge);• A limitation of sale/leaseback transactions;and• A limitation on mergers, consolidations, orsales of assets.As one moves to speculative-grade transac-

tions, other covenants are usually added tothose above. Some of the most common are:

• Limitations on the incurring of additionaldebt (including debt at subsidiary levels),

• Restrictions on certain payments (includ-ing dividends, stock purchases, loans, andinvestments), • Changes of control provisions, and• Net-worth maintenance requirements.Bank loan agreements may also contain pro-

visions for periodic paying down of outstand-ing balances.

Over time, the lists will change, as the mar-ket’s willingness to accept certain conditionschanges. (For example, in the late 1980s andearly 1990s, when event risk loomed large dueto LBOs and takeovers, issues that containedcovenants providing event-risk protection typ-ically enjoyed a price advantage over thosewithout such protection. With the end of theLBO boom, however, the market no longerdemanded these clauses).

When reviewing a covenant package for anypurpose, it is necessary to check its terms anddefinitions carefully. What is and—sometimes,what is more important—what is not includedsignificantly affect the level of protection.Often, specified ratio calculations are not stan-dardized, and it may be necessary to havemanagement supply calculations and compli-ance documents.



Ratings and Ratios

51 CRITERIA TOPICS � Corporate Ratings Criteria

Presented on the next pages are key ratiomedians for U.S. corporates by rating category.Definitions of the ratios appear on page 55.The ratio medians are purely statistical, andare not inteded as a guide to achieving a givenrating level. Ratio Guidelines are presented onpage 56. They more faithfully represent therole of ratios in the ratings process.

Ratios are helpful in broadly defining a com-pany’s position relative to rating categories. Theyare not intended to be hurdles or prerequisitesthat should be achieved to attain a specific debtrating.

Caution should be exercised when using theratio medians for comparisons with specific com-pany or industry data because of major differ-ences in method of ratio computation, impor-tance of industry or business risk, and impact ofmergers and acquisitions. Since ratings aredesigned to be valid over the entire business cycle,ratios of a particular firm at any point in the cyclemay not appear to be in line with its assigneddebt ratings. Particular caution should be usedwhen making cross-border comparisons, due todifferences in accounting principles, financialpractices, and business environments.

Financial ratio medians are adjusted forunusual items and to capitalize operating leases.

Company data are adjusted for the following:• Nonrecurring gains or losses are eliminat-

ed from earnings. This includes gains on assetsales, significant transitory income items,unusual losses, losses on asset sales, andcharges due to asset writedowns, plant shut-downs, and retirement programs. Theseadjustments chiefly affect interest coverage,return, and operating margin ratios.

• Unusual cash flow items similar in originto the nonrecurring gains or losses are alsoreversed.

• The operating lease adjustment is performedfor all companies. Companies that buy all plantand equipment are put on a more comparablebasis with firms that lease part or all of their oper-ating assets. The lease adjustment impacts allratios.

Still, several adjustments commonly made byStandard & Poor’s analysts are not incorporat-ed in the adjusted medians. Omitted are alter-ations reflecting net debt and the captivefinance company methodology. The net debtadjustment would affect median ratios largelyfor the ‘AAA’ rating category, which is almostentirely composed of cash-rich pharmaceuticalcompanies. (If the net debt adjustment weremade, interest coverage, cash flow to debt, anddebt ratios for the ‘AAA’ category would not bemeaningful, since many of these firms have nonet debt.) The captive finance adjustment has agreater effect, mainly on automobile, depart-ment store, and some capital goods companies.

The adjusted ratio median universe includesabout 500 companies. The data exclude com-panies, such as the auto manufacturers andcable television firms, that, even with adjust-ments, have financial ratios that are not repre-sentative of those used in the rating process.

The medians themselves are affected byeconomic and environmental factors, as wellas mergers and acquisitions. The universe ofrated companies is constantly changing, and incertain rating categories, adding or deleting afew companies can materially change thefinancial ratio medians.

Strengths and weaknesses in different areashave to be balanced and qualitative factorsevaluated. There are many nonnumeric distin-guishing characteristics that determine acompany’s creditworthiness.


Ratio Medians

RATINGS AND RATIOS � Corporate Ratings Criteria 53

54 RATINGS AND RATIOS � Corporate Ratings Criteria



U.S. Industrial long term debtThree-year (1998 to 2000) medians AAA AA A BBB BB B CCCEBIT int. cov. (x) 21.4 10.1 6.1 3.7 2.1 0.8 0.1EBITDA int. cov. (x) 26.5 12.9 9.1 5.8 3.4 1.8 1.3Free oper. cash flow/total debt (%) 84.2 25.2 15.0 8.5 2.6 (3.2) (12.9)FFO/total debt (%) 128.8 55.4 43.2 30.8 18.8 7.8 1.6Return on capital (%) 34.9 21.7 19.4 13.6 11.6 6.6 1.0Operating income/sales (%) 27.0 22.1 18.6 15.4 15.9 11.9 11.9Long-term debt/capital (%) 13.3 28.2 33.9 42.5 57.2 69.7 68.8Total debt/capital (incl. STD) (%) 22.9 37.7 42.5 48.2 62.6 74.8 87.7Companies 8 29 136 218 273 281 22

Data for earlier years and in greater detail are available by subscribing to Standard & Poor’s CreditStats.

U.S. Electric Utility long-term debtFor 12 months ended Sept. 2001 AA A BBB BBEBIT interest coverage (x) 4.2 3.4 2.8 1.9Preferred dividend coverage (x) 4.1 3.3 2.7 1.8

8.2 10.4 11.2 6.273.3

2.3 3.0 2.7 4.550.9 43.2 39.6 26.1

Funds from operations interest coverage 5.1 4.0 3.5 2.4Funds from operations/total debt (%)Net cash flow/capital expenditures (%) 97.5 74.8 80.6 65.2

EBIT—Earnings before interest and taxes. EBITDA—Earnings before interest, taxes, depreciation, and amortization.

ADJUSTED KEY INDUSTRIAL FINANCIAL RATIOS

KEY UTILITY FINANCIAL RATIOS

Return on equity (%)Common dividend payout (%) 33.981.681.792.3

12.5 10.912.3 11.4

Short term debt/capital (%)Total debt/capital (%)Preferred stock/capital (%)Common stock/capital (%)

51.7 55.92 58.78

23.76 20.42 12.4735.5




� STANDARD & POOR’S� STANDARD & POOR’S� STANDARD & POOR’S� STANDARD & POOR’S� STANDARD & POOR’S� STANDARD & POOR’S� STANDARD & POOR’S� STANDARD & POOR’S

FORMULAS FOR KEY RATIOS1. EBIT interest coverage = Earnings from continuing operations* before interest and taxes

Gross interest incurred before subtracting (1) capitalized interest and (2) interest income

2. EBITDA interest coverage = Earnings from continuing operations* before interest, taxes, depreciation, and amortizationGross interest incurred before subtracting (1) capitalized interest and (2) interest income

3. Funds from operations/total debt = Net income from continuing operations plus depreciation, amortization, deferred income taxes, and other noncash items Long-term debt** plus current maturities, commercial paper, and other short-term borrowings

4. Free operating cash flow/total debt = Funds from operations minus capital expenditures, minus (plus) the increase (decrease) in working capital (excluding changes in cash,

marketable securities, and short-term debt) Long-term debt** plus current maturities, commercial paper, and other short-term borrowings

5. Return on capital = EBIT Average of beginning of year and end of year capital, including short-term

debt, current maturities, long-term debt**, non-current deferred taxes, and equity.

6. Operating income/sales = Sales minus cost of goods manufactured (before depreciation and amortization), selling, general and administrative, and research and development costs

Sales

7. Long-term debt/capital = Long-term debt** Long-term debt + shareholders’ equity (including preferred stock) plus minority interest

8. Total debt/capital = Long-term debt** plus current maturities, commercial paper, and other short-term borrowings Long-term debt plus current maturities, commercial paper, and other short-term borrowings

+ shareholders’ equity (including preferred stock) plus minority interest

*Including interest income and equity earnings; excluding nonrecurring items.**Including amount for operating lease debt equivalent.

Risk-adjusted ratio guidelines depict the rolethat financial ratios play in Standard & Poor’srating process, since financial ratios are viewedin the context of a firm’s business risk. A com-pany with a stronger competitive position,more favorable business prospects, and morepredictable cash flows can afford to undertakeadded financial risk while maintaining thesame credit rating.

The guidelines displayed in the matricesmake explicit the linkage between financialratios and levels of business risk. For example,consider a U.S. industrial—which includesmanufacturing, service, and transportationsectors—with an average business risk profile.Cash flow coverage of 60% would indicate an‘A’ rating. If a company were below average, itwould need about 85% cash flow coverage toqualify for the same rating. Similarly, for the‘A’ category, a firm that has an above-averagebusiness risk profile could tolerate about 40%

leverage and an average firm only 30%. Thematrices also show that a company with onlyan average business position could not aspireto an ‘AAA’ rating, even if its financial ratioswere extremely conservative.

Ratio medians that Standard & Poor’s hasbeen publishing for more than a decade aremerely statistical composites. They are notrating benchmarks, precisely because theygloss over the critical link between a compa-ny’s financial risk and its business risk.Medians are based on historical performance,while Standard & Poor’s risk-adjusted guide-lines refer to expected future performance.

Guidelines are not meant to be precise.Rather, they are intended to convey ranges thatcharacterize levels of credit quality as repre-sented by the rating categories. Obviously,strengths evidenced in one financial measurecan offset, or balance, relative weakness inanother.


Ratio Guidelines





� STANDARD & POOR’S� STANDARD & POOR’S� STANDARD & POOR’S� STANDARD & POOR’S

U.S. INDUSTRIALSManufacturing, Service and Transportation Companies

Funds from Operations/Total Debt Guidelines (%)—Rating category—

Company business risk profile AAA AA A BBB BBWell above average business position 80 60 40 25 10Above average 150 80 50 30 15Average — 105 60 35 20Below average — — 85 40 25Well below average — — — 65 45

Total Debt/Capitalization Guidelines (%)—Rating category—

Company business risk profile AAA AA A BBB BBWell above average business position 30 40 50 60 70Above average 20 25 40 50 60Average — 15 30 40 55Below average — — 25 35 45Well below average — — — 25 35


U.S. UTILITIES

Funds from Operations/Total Debt Guidelines (%)—Rating category—

Company businessrisk profile AAA AA A BBB BB B

Well-above-average 1 23 18 15 10 5 —business position 2 29 23 19 14 9 —Above average 3 35 29 23 17 12 7

4 40 34 28 21 15 9Average 5 46 37 30 24 18 11

6 53 43 35 27 19 13Below average 7 63 52 42 31 21 14

8 75 61 49 35 23 15Well below average 9 — — 57 41 27 17

10 — — 69 50 34 22

Total Debt/Capitalization (%)—Rating category—

Company businessrisk profile AAA AA A BBB BB B

Well-above-average 1 47 53 58 64 70 —business position 2 43 49 54 60 66 —Above average 3 39 45 50 57 64 70

4 35 41 46 53 61 68Average 5 33 39 44 51 59 67

6 30 36 43 50 57 65Below average 7 27 34 41 49 56 64

8 23 31 39 47 55 62Well below average 9 — — 35 43 51 58

10 — — 29 37 43 50


Rating the Issue

RATING THE ISSUE � Corporate Ratings Criteria 61

Standard & Poor’s assigns two types of cred-it ratings—one to corporate issuers and theother to specific corporate debt issues (or otherfinancial obligations). The first type is called aStandard & Poor’s corporate credit rating. It isa current opinion on an issuer’s overall capaci-ty to pay its financial obligations—that is, itsfundamental creditworthiness. This opinionfocuses on the issuer’s ability and willingness tomeet its financial commitments on a timelybasis. It generally indicates the likelihood ofdefault regarding all financial obligations of thefirm, since companies that default on one debttype or file under the Bankruptcy Code virtual-ly always stop payment on all debt types. Itdoes not reflect any priority or preferenceamong obligations. In the past, Standard &Poor’s published the “implied senior-most rat-ing” of corporate obligors, which is a differentterm for precisely the same concept. “Defaultrating” and “natural rating” are additionalways of referring to this issuer rating.

Generally, a corporate credit rating is pub-lished for all companies that have issue ratings—in addition to those firms who have no rat-able issues, but request just an issuer rating.Where it is germane, both a local currency andforeign currency issuer rating are assigned.

Standard & Poor’s also assigns credit ratingsto specific issues. In fact, the vast majority ofcredit ratings pertain to specific debt issues.Issue ratings also take into account the recov-ery prospects associated with the specific debtbeing rated. Accordingly, junior debt is ratedbelow the corporate credit rating. Preferredstock is rated still lower (see chapter on pre-ferred stock, page 84). Well-secured debt canbe rated above the corporate credit rating.

Notching: An overviewThe practice of differentiating issues in rela-

tion to the issuer’s fundamental creditworthi-ness is known as “notching.” Issues arenotched up or down from the corporate creditrating level.

Payment on time as promised is obviouslycritical with respect to all debt issues. Thepotential for recovery in the event of a default—that is, ultimate recovery, albeit delayed—isalso important, but timeliness is the primaryconsideration. That explains why issue ratingsare still anchored to the corporate credit rat-ing. They are notched—up or down—from thecorporate credit rating in accordance withestablished guidelines.

Notching guidelines are explained in thechapters that follow. They take into accountthe degree of risk/confidence with respect torecovery. But the guidelines also reflect a con-vention for blending the two rating aspects,namely, timeliness and recovery potential.

A key principle is that investment-grade rat-ings focus more on timeliness, while non-investment grade ratings give additionalweight to recovery. For example, subordinat-ed debt can be rated up to two notches belowa noninvestment grade corporate credit rating,but one notch at most if the corporate creditrating is investment grade. Conversely, a verywell-secured bank loan or first mortgage bondwill be rated one notch above a corporatecredit rating in the ‘BBB’ or ‘A’ rating cate-gories—but the enhancement would be twonotches in the case of a ‘BB’ or ‘B’ corporatecredit rating. In the same vein, the ‘AAA’ rat-ing category need not be notched at all, whileat the ‘CCC’ level the gaps may widen.

The rationale for this convention is straight-forward: as the default risk increases, the con-cern over what can be recovered takes ongreater relevance and, therefore, greater ratingsignificance. Accordingly, the ultimate recov-ery aspect of ratings is given more weight asone moves down the rating spectrum.

There is also an important distinctionbetween notching up and notching down.Whenever a financial obligation is judged tohave materially worse recovery prospect thanother debt of that issuer—by virtue of its beingunsecured, subordinated, or because of a hold-


Distinguishing Issuers and Issues

62 RATING THE ISSUE � Corporate Ratings Criteria


ing company structure—the issue rating isnotched down. Thus, priority in bankruptcy isconsidered in broad, relative terms; there is nofull-blown attempt to quantify the potentialseverity of loss. And, since the focus is relativeto the various obligations of the issuer, nocomparison between issues of different compa-nies is warranted. For example, the fact that asenior issue of company A is not notched at alldoes not imply anything about its recoveryprospects relative to the junior debt of compa-ny B—with the same corporate credit rating—which is notched down.

In contrast, issue ratings are not enhancedabove the corporate credit rating unless a com-prehensive analysis indicates the likelihood offull recovery—100% of principal—for thatspecific issue. The degree of confidence of fullrecovery that results from this more rigorousanalysis is reflected in the extent that the issueis notched up. If the analysis concludes thatrecovery prospects may be less than 100%, the

issue is not deemed deserving of ratingenhancement, even though it can be valuableindeed to realize, say, 80% or 90% of one’sinvestment and avoid a greater loss!

The entire notion of junior obligations—andthe related difference it makes with respect torecovery prospects—is specific to the applica-ble legal system. Notching guidelines are,therefore, a function of the bankruptcy lawand practice in the legal jurisdiction that gov-erns a specific instrument. For example, distin-guishing between senior and subordinateddebt can be meaningless in India, where com-panies may be allowed to continue paying evencommon dividends, at the same time that theyare in default on debt obligations. Accordingly,notching is not applied in India! The majorityof legal systems broadly follow the practicesunderlying Standard & Poor’s criteria fornotching—but it is always important to beaware of nuances of the law as they pertain toa specific issue.


When a debt issue is judged to be junior toother debt issues of the company, and, there-fore, to have relatively worse recoveryprospects, that issue is assigned a lower rating

corporate credit rating. As a matter of ratingpolicy, the differential is limited to one ratingdesignation in the investment-grade categories.For example, when the corporate credit rating

speculative-grade categories, where the possi-bility of a default is greater, the differential isup to two rating designations.

Notching relationships are based on broadguidelines that combine consideration of assetprotection and ranking. The guidelines aredesigned to identify material disadvantage fora given issue by virtue of the existence of bet-ter-positioned obligations. The analyst doesnot seek to predict specific recovery levels,which would involve knowing the exact assetmix and values at a point well into the future.

Notching relationships are subject to reviewand change when actual developments varyfrom expectations. Changes in notching do notnecessarily have to be accompanied by changesin default risk.

Guidelines for notchingTo the extent that certain obligations have a

ranking obligations are at a disadvantagebecause a smaller pool of assets will be avail-able to satisfy the remaining claims. One caseis when the issue is contractually subordinat-ed—that is, the terms of the issue specificallyprovide that debt holders will receive recoveryin a reorganization or liquidation only afterthe claims of other creditors have been satis-fied. Another case is when the issue is unse-cured and assets representing a significant por-

by secured borrowings. A third form of disad-vantage can arise if a company conducts itsoperations through one or more legally sepa-

rate subsidiaries, but issues debt at the parent(i.e., holding company) level. In this case, if thewhole group declares bankruptcy, creditors ofthe subsidiaries—including holders of evencontractually subordinated debt—would have

creditors of the parent would have only ajunior claim, limited to the residual value of

The disadvantage of parent company credi-tors owing to the parent/subsidiary legal struc-

among many small subsidiaries, whose indi-vidual debt obligations have only dubiousrecovery prospects, the parent company credi-tors may still be disadvantaged compared witha situation in which all creditors would havean equal claim on the assets.

As a rough measure of asset availability,

priority debt and other liabilities relative to allavailable assets. When this ratio reaches cer-tain threshold levels, the disadvantaged debt israted one or two notches below the corporatecredit rating. These threshold levels take intoaccount that it normally takes more than $1 ofbook assets—as valued today—to satisfy $1 ofpriority debt. (In the case of secured debt—which limits the priority to the collateralpledged—the remaining assets are still less


Junior Debt: Notching Down

Investment-Grade ExampleCorporate Credit Rating: ‘A’

Issue ratingsAssets $100 Priority debt $30 A

Lower-priority debt $10 A-Equity $60

The lower-priority debt is rated one notch below thecorporate credit rating of ‘A’, since the ratio of prioritydebt to assets (30 to 100) is greater than 20%.

§ §is ‘A’, junior debt may be rated ‘A-’. In the

than—that is, it is “notched down” from—thethe first claim to the subsidiaries’ assets, while

the subsidiaries’ assets remaining after the sub-

Even if the group’s operations are splinteredture is known as “structural subordination.”

sidiaries’ direct liabilities have been satisfied.

priority claim on the company’s assets, lower-

Standard & Poor’s looks at the percentage of

tion of the company’s value are collateralized

likely to suffice to repay the unsecured debt,inasmuch as the collateral ordinarily consists

tially exceeds the amount of the debt.)For investment-grade companies, the thresh-

old is 20%. That is, if priority debt and liabil-

the lower-priority debt (unsecured, subordi-nated, or holding company) is rated one notchbelow the corporate credit rating.

If the corporate credit rating is speculativegrade, there are two threshold levels. If priori-ty obligations equal even 15% of the assets,the lower-priority debt is penalized one notch.When priority debt and other liabilitiesamount to 30% of the assets, lower-prioritydebt is substantially disadvantaged and is,therefore, differentiated by two notches.

Multiple layersA business entity can have many levels of

obligations, each ranking differently withrespect to priority of claim in a bankruptcy.

For analytical purposes, debt levels are rankedas follows, from highest priority to lowest:

• Debt secured with higher-quality operat-ing asset collateral• Debt secured with lesser-quality operatingasset collateral• Senior debt of the operating company• Senior liabilities (rank pari passu withsenior debt)• Subordinated debt• Junior subordinated debt• All other operating company liabilities• Senior debt of the holding company• Subordinated debt of the holding companyOnce a notching threshold level is crossed—

aggregating successive layers of priorityclaims—notching applies to the remaining,lower-ranking issues (see illustration below).

If the priority claims do not quite reach athreshold level, but the preponderance of thenext-lower debt level is below the threshold,those claims may be considered disadvantagedand notched accordingly. (Senior subordinateddebt is sometimes subordinated only withrespect to senior debt, but is pari passu withother liabilities. In other instances, it may besubordinated to other liabilities as well. Itsposition in the priority of levels, therefore,depends on the specific terms of each issue.)

The reason notching is constrained to onenotch for investment-grade companies andtwo notches for speculative-grade firms is tomaintain the important weighting of timelinessin all ratings. Remember, notching pertainsonly to differentiating recovery prospects—it ispresumed that a default will interrupt payment



Speculative-Grade ExampleCorporate Credit Rating: ‘BB+’

Issue ratingsAssets $100 Priority debt $35 BB+

Lower-priority debt $20 BB-Equity $45

The lower-priority debt is rated two notches below thecorporate credit rating of ‘BB+’, since the ratio of prior-ity debt to assets (35 to 100) is greater than 30%.

of the firm’s better assets and often substan-

ities equal 20% or more of the firm’s assets,


highest ranking issues receive the corporatecredit rating, or sometimes a higher rating, iffull recovery is confidently expected (see nextchapter); the lowest ranking issues will neverbe rated lower than one notch under theinvestment-grade corporate credit rating, ortwo notches in the case of non-investment-grade corporate credit ratings. This rating con-vention often results in debt issues of signifi-cantly different standing being rated the same!

Issue ratings are always notched from thetop down, as indicated by the examples. If atwo-notch distinction is indicated, the gap isnot narrowed to highlight the contrastbetween that junior issue and worse-positioned issues.

Senior secured debt. Not all senior secureddebt of an issuer is necessarily equally secured.Second-mortgage debt, for example, has only ajunior claim to an asset also securing first-mortgage debt, making it inferior to a first-mortgage issue secured by the same asset. Thesecond-mortgage debt issue would receive thecorporate credit rating only if the amount offirst-mortgage debt outstanding was sufficient-ly small relative to the assets.

Debt issues are often secured by differentcollateral of varying quality. If the collateralthat secures a particular issue is of dubiousvalue, that secured debt may be notched downfrom the corporate credit rating. For example,if a manufacturing company had borrowingsunder a bank credit facility secured by high-quality receivables and relatively liquid inven-tory, a senior secured debt issue that was col-lateralized with only relatively illiquid proper-ty, plant, and equipment could well be rated

Application of guidelinesPerspective. Notching takes into account

expected future developments. For example, acompany may be in the process of refinancingsecured debt so that it would have little or nosecured debt within a year. If there is confi-dence that the plan will be carried out, anotching differential should not be needed,even today. Conversely, if companies haveopen first-mortgage indentures or the leewayto increase secured borrowings under negativepledge covenants (or if no negative pledge

attempts to determine the likelihood that thecompany will incur additional secured borrow-ings. But the analyst would not automaticallybase notching on the harshest assumptions.

If an issuer has a secured bank credit facili-ty, such borrowings would be reflected innotching to the extent that the issuer wasexpected to draw on the facility. In general, thelower the corporate credit rating, the greaterthe likelihood that the issuer will need to tapits sources of financing. In the absence ofexpectations to the contrary, Standard &

ing that available bank borrowing capacity isfully utilized. Likewise, if a company typicallyuses bank borrowings to fund seasonal work-

focuses on expected peak borrowing levels,rather than the expected average amount.

Adjustments. Book values are used as astarting point; analytic adjustments are made ifassets are considered significantly overvaluedor undervalued for financial accounting pur-poses. This analysis focuses on the varyingpotential of different types of assets to retainvalue over time and in the default contextbased on their liquidity characteristics, special-purpose nature, and dependence on the health


Speculative-Grade ExampleCorporate Credit Rating: ‘BB+’


Lower-priority debt $15 BBEquity $60

Here, assuming the issuer was speculative grade, thelower-priority debt might be rated one notch below thecorporate credit rating, rather than two notches,although the ratio of priority debt to assets (25 to 100)is close enough to the guideline threshold of 30% tomake this a borderline case.


Lower-priority debt $30 BB-Equity $45

In this case, the lower-priority debt should be rated twonotches below the corporate credit rating. Although theratio of priority debt to assets is still 25 to 100, the sub-stantial amount of lower-priority debt would diluterecoveries for all lower-priority debtholders.

on all of a company’s debt issues. The very

below that company’s corporate credit rating.

covenants are in place), Standard & Poor’s

Poor’s takes a conservative approach, assum-

ing capital requirements, Standard & Poor’s

of the company’s business. Goodwill is

especially suspect, considering its likely valuein a default scenario. In applying the notching

nates from total assets goodwill in excess of a

particular characteristics of specific intangi-bles, as distinct from goodwill, are considered.(For example, some credit is typically given forthe enduring value of well-established brandsin the consumer products sector.) Standard &

asset appraisals or attempt to postulate specif-ically how market values might fluctuate in ahypothetical stress scenario.

In applying the guidelines above, lease oblig-

financial reporting or kept off balance sheet asoperating leases—and the related assets underleases are included. Similarly, sold trade receiv-ables and securitized assets are added back,along with an equal amount of debt. Othercreditors are just as disadvantaged by suchfinancing arrangements as by secured debt. Inconsidering the surplus cash and marketablesecurities of companies that presently are

neither that the cash will remain available inthe default scenario, nor that it will be totallydissipated, but rather that, over time, this cashwill be reinvested in operating assets that mir-

to erosion in value of the same magnitude.Local and foreign currency issue ratings. In

determining local currency issue ratings, thepoint of reference is the local currency corpo-rate credit rating: local currency issue ratingsmay be notched down one notch from thelocal currency corporate credit rating in thecase of investment-grade issuers, or one or twonotches in the case of speculative-grade issuers.

it rating is often lower than its local currencycorporate credit rating, reflecting the risk thata sovereign government could take actions that

meet foreign currency obligations. But juniorforeign currency issues are not notched downfrom the foreign currency corporate credit rat-ing, as the government action would applyregardless of the senior/junior character of thedebt. Of course, the issue would never be ratedhigher than if it had been denominated in local

currency corporate credit rating were ‘BB+’and its foreign currency corporate credit rating

were ‘BB-’, subordinated foreign currency-denominated issues could be rated ‘BB-’. But, if

rating were ‘BB+’ and its foreign currency cor-porate credit rating were ‘BB’, subordinatedforeign currency-denominated issues would berated ‘BB-’, just as subordinated local currency-denominated issues would.

Commercial paper. Commercial paper rat-

rating (see page 79). Although commercialpaper is generally unsecured, commercialpaper ratings focus exclusively on default risk.For example, if an issuer has an ‘AA-’ corpo-rate credit rating and secured debt issue ratingand an ‘A+’ unsecured rating, its commercialpaper rating would still be ‘A-1+’—the com-mercial paper rating associated with the ‘AA-’issuer default rating—not ‘A-1’, the commer-cial paper rating ordinarily appropriate at the‘A+’ default risk rating level.

Parents and subsidiaries: Structuralsubordination

At times, a parent and its affiliate grouphave distinct default risks. The difference inrisk may arise from covenant restrictions, reg-ulatory oversight, or other considerations.This is the norm for holding companies ofinsurance operating companies and banks. Insuch situations, there are no fixed limits gov-erning the gaps between corporate credit rat-ings of the parent and its subsidiaries. Theholding company has higher default risk, apartfrom post-default recovery distinctions. If sucha holding company issued both senior andjunior debt, its junior obligations would be

porate credit rating by one or two notches.Often, though, a parent holding company

with one or more operating companies isviewed as a single economic entity. When thedefault risk is considered the same for the par-ent and its principal subsidiaries, they areassigned the same corporate credit rating. Yet,in a liquidation, holding company creditors areentitled only to the residual net worth of theoperating companies remaining after all oper-ating company obligations have been satisfied.

Parent-level debt issues are not alwaysnotched down to reflect structural subordina-tion; this is done only when the priority liabil-ities create a material disadvantage for the par-

ing factors (discussed below). In considering



guidelines, Standard & Poor’s generally elimi-

Poor’s does not, however, perform detailed

ations—whether capitalized in the company’s

financially healthy, Standard & Poor’s assumes

ror the company’s current asset base, subject

A company’s foreign currency corporate cred-

would impinge on the company’s ability to

currency. For example, if a company’s local

a company’s local currency corporate credit

ings are linked to the issuer’s corporate credit

notched relative to the holding company’s cor-

ent’s creditors, taking into account all mitigat-

“normal” amount—10% of total assets. The



the appropriate rating for a specific issue ofparent-level debt, priority liabilities encompassall third-party liabilities (not just debt) of thesubsidiaries—including, for example, tradepayables, pension and retiree medical liabili-ties, and environmental liabilities—plus anyrelatively better-positioned parent-level liabili-ties. (For example, parent-level borrowingscollateralized by the stock of the subsidiarieswould be disadvantaged relative to subsidiaryliabilities, but would rank ahead of unsecuredparent-level debt.)

Potential mitigating factors. Even if materialliabilities exist at the subsidiary level, otherfactors may offset the disadvantage this posesto parent company creditors.

Guarantees. Guarantees by the subsidiariesof parent-level debt (i.e., upstream guarantees)may overcome structural subordination byputting the claims of parent company creditorson a pari passu basis with those of operatingcompany creditors, if such guarantees areenforceable under the relevant national legalsystem(s) and if the circumstances do not causeundue concern regarding potential allegationsof fraudulent conveyance (see sidebar:“Upstream Guarantees”). Although joint andseveral guarantees from all subsidiaries pro-vide the most significant protection, severalguarantees by subsidiaries accounting for amajor portion of total assets would be suffi-cient to avoid notching of parent debt issues inmost cases.

Operating assets at the parent. Althoughsome businesses are conducted through sub-sidiaries, the parent often is not a pure holdingcompany, but rather also directly owns certainoperating assets. This direct ownership givesthe parent creditors a priority claim to the par-ent-level assets, offsetting, at least partially, thedisadvantage that stems from the parent'sclaims being structurally subordinated to theassets owned by the subsidiaries.

Diversity. When the parent owns multipleoperating companies, more liberal notchingguidelines may be applied to reflect the benefitthe diversity of assets might provide. Thethreshold guidelines are relaxed (but not elim-inated) to correspond with the extent of busi-ness and/or geographic diversification of thesubsidiaries. For bankrupt companies thatown multiple, separate business units, theprospects for residual value remaining forholding company creditors improve as individ-ual units wind up with shortfalls and surplus-

es. And for healthy, well-diversified compa-nies, one can presume that their structure willchange significantly on the way to a default,

tion less relevant. Holding companies with diverse business-

es—in terms of product or geography—havegreater opportunities for dispositions, assettransfers, or recapitalization of subsidiaries. If,however, the subsidiaries are operationallyintegrated, economically correlated, or regu-

is more limited. For example, Standard &

globally integrated commodities company, incontrast to a multinational retailer with large-ly autonomous regional operations.

Concentration of debt. If a parent has anumber of subsidiaries, but the preponderanceof subsidiary liabilities are concentrated in oneor two of these, e.g., industrial groups havingfinance or trading units, this concentration ofliabilities can limit the disadvantage for parentcompany creditors. Although the net worth ofthe leveraged units could well be eliminated inthe bankruptcy scenario, the parent might stillobtain recoveries from its relatively unlever-aged subsidiaries. In applying the notchingguideline in such cases, it may be appropriateto eliminate the assets of the leveraged sub-sidiary from total assets, and its liabilities frompriority liabilities. (The analysis then focuseson the assets and liabilities that remain, but thestandard notching guideline must be substitut-ed by other judgments regarding recoveryprospects.)

Downstream loans.ment in a subsidiary is not just an equity inter-est, but also takes the form of downstreamsenior loans, this may enhance the standing ofparent-level creditors because they would have

net worth, but also a debt claim that wouldgenerally be pari passu with other debt claims.

documented loans—not to informal advances,which are highly changeable. (On the otherhand, if the parent has borrowed funds fromits subsidiaries, the resulting intercompanyparent-level liability could further dilute therecoveries of external parent-level creditors.)As with guarantees, the assessment of down-stream advances must take into account theapplicable legal framework.

lated, the company’s flexibility to reconfigure

Poor’s would give little credit for diversity to a

If the parent’s invest-

not only a residual claim on the subsidiary’s

Standard & Poor’s gives weight to formal,

making today’s apparent structural subordina-

Given the endless variety of circumstances,there is no mechanical formula for combiningthese mitigating factors. Enforceable upstreamguarantees from some major subsidiaries willgenerally be sufficient to avoid notching. Forwell-diversified investment-grade companies,the guideline threshold may be relaxed up to50%, and the presence of additional mitigantsmay warrant some additional leeway.

Adjustments. Additional adjustments arenecessary in assessing structural subordination.

and liabilities and other accounting accrualsand provisions that are not likely to have cleareconomic meaning in a default.

Exceptions to the ruleIf the recovery prospects for a specific junior

issue equate to the level associated with seniordebt generally, notching is dispensed with. As

can be reasonably anticipated, the junior debtis not notched below the senior debt.

Only a handful of rated junior issues providefor such good recovery prospects. In each case,there are assets that serve as collateral—andthese assets’ value is not dependent on the fateof the issuer. For example,

• A major U.S. pharmaceutical company mar-keted subordinated capital securities that explic-itly provide for the possibility of future contribu-tion of financial assets as collateral. In that case,the rating of the issue would be raised—therewould be no need to notch for subordination—and the coupon would be reset downward. Inthis instance, the collateral needed to warrant anupgrade would be spelled out in a detailed sched-ule that takes into account the quality and tenorof such collateral, as well as the option toperiodically “top-up” the collateral.

• There a few confidential ratings for pri-vately-placed preferred issues of subsidiariesformed to own stock in companies that areunrelated to the ultimate parent. The parentcompanies guarantee payment. Although theissues are subordinated to the senior debt of theparents with respect to most of the assets, thepreferred holders benefit from a prior claim onthe shares. In each case, the current marketvalue of these shareholdings is a multiple of theissuing company liabilities. While, on the onehand, equity values are not especially reliable,the preferred issues are highly “overcollateral-ized” with assets whose value is not tied to thefate of their parent company. Arguably, the pre-ferred holders should fare at least as well as theparents’ senior creditors—whose claim will beagainst the assets of a bankrupt entity.

• Some mandatory equity financings involvecontracts where the investors’ obligation to pur-chase common equity is secured by Treasuries.The rating addresses the company’s ability tohonor its obligations: periodic payments (inaddition to the interest on the Treasury securi-ties) and issuance of common stock at the end



Single Economic Entity Example

Parent—Corporate Credit Rating: ‘BB+’Debt type* Issue ratingSenior secured BB-Senior unsecured BB-Subordinated BB-

Subsidiary—Corporate Credit Rating: ‘BB+’Debt type* Issue ratingSenior secured BB+Senior unsecured BBSubordinated BB-

Different Default Risk Example

Parent—Corporate Credit Rating: ‘BB+’Debt type* Issue ratingSenior secured BB+Senior unsecured BBSubordinated BB-

Subsidiary—Corporate Credit Rating: ‘B+’Debt type* Issue ratingSenior secured B+Senior unsecured BSubordinated B-*Debt types are used here merely as illustrative of typ-ical results for different priority debt; notching actuallydepends on the guidelines explained above.

In the first example, since the parent and subsidiaryare viewed as having the same default risk, the lowestrating at either is two notches below the single corporatecredit rating. If the parent is a holding company withoutassets other than its ownership interest in the subsidiary,the parent’s debt is viewed as junior and notched down.In contrast, in the second example, the parent and sub-sidiary are viewed as having different default risks, soeach has a different corporate credit rating (assumed tobe ‘BB+’ at the parent and ‘B+’ at the subsidiary) and thetwo-notch limit is relative to the corporate credit ratingsat each entity: there is no limit on the span of ratings thatapplies across the two legal entities.

Standard & Poor’s eliminates from the notch-

long as recovery of 75-85 cents on the dollar

ing calculations subsidiaries’ deferred tax assets

of three years in return for the Treasuries. Thereturn to the investor is a function of the com-

company obligation is subordinated.With respect to these and similar cases,

Standard & Poor’s does not presume any spe-cific level of recovery for the senior creditors ofthe company in question. The senior debtcould still, in the end, fare better than the col-lateralized subordinated issue—or it mightcome out with lesser recovery. The key: Aslong as the subordinated debt should recover

as much as the vast majority of defaultedsenior debt, it is not discernibly disadvantagedand does not deserve to be notched down.

The average recovery for senior unsecureddebt is about 50%; for senior secured the aver-age is 65%. But the criterion is not defined interms of the average; half of all cases do betterthan that. Recovery of 75%-85% would com-pare favorably with that experienced byroughly three-quarters of senior creditors.

Note that it is not necessary to conclude thatholders will be made whole to eliminate thenotching down of subordinated obligations.Obligations that are likely to provide full ulti-mate recovery are rated above the corporatecredit rating (see “Notching Up”).



When a subsidiary guarantees the debt ofits parent, that is commonly referred to as anupstream guarantee. The object of the exerciseis to address the structural subordination thatwould otherwise apply to parent-company debtif the debt, liabilities, and preferred stock ofthe operating company are material. Upstreamguarantees, if valid, eliminate the rating dis-tinction, since the operating companybecomes directly responsible for the guaran-teed parent debt. However the validity of theguarantee is subject to legal risk. An upstreamguarantee may be voided in court, if it isdeemed to constitute a fraudulent conveyance.The outcome depends on the specific factpattern, not legal documentation—so onecannot standardize the determination. But, ifeither the guarantor company received value orwas solvent for a sufficiently long period sub-sequent to issuing the guarantee, the upstreamguarantee should be valid.

Accordingly, Standard & Poor’s considersupstream guarantees valid if any of theseconditions are met:

1) The proceeds of the guaranteed obliga-tion are provided to (downstreamed to)

the guarantor. It matters not whether theissuer downstreams the money as anequity infusion or as a loan. Either way,the financing benefits the operations ofthe subsidiary, which justifies theguarantee.

2) The legal risk period—ordinarily one or two years from entering into the guarantee—has passed, or

3) There is a specific analytical conclusionthat there is little default risk during theperiod that the guarantee validity is atrisk, or

4) The rating of the guarantor is at least‘BB-’ in jurisdictions that involve a two-year risk, or at least ‘B+’ in jurisdictionswith one-year risk.

Accordingly, there will be cases whereStandard & Poor’s declines to recognize theupstream guarantee at the time of issuance—due to legal risk—but would upgrade the issuea year (or two) later.

Accordingly, Standard & Poor’s accepts anupstream guarantee whenever the guarantorobtained value. As long as the guarantor is therecipient of the funds, it meets this test.

UPSTREAM GUARANTEES

pany bankruptcy in the interim, the investors

mon stock value: this risk is not addressed by thecredit rating. However, in the event of a com-

get the Treasuries back. Therefore, the rating isthe same as the corporate credit rating, even if the



In 1996, Standard & Poor’s first published itsframework for weighting both timeliness andrecovery prospects in assigning ratings to well-secured debt. The extent of any enhancementdepends on the following three considerations:

Economics. Will the “second way out” pro-vide 100% recovery? of principal only? ofinterest, too? (If all accrued interest, beforeand after default, can be recovered, the lengthof any delay is less consequential.)

Importantly, there can be different degrees ofconfidence with respect to recovery. For exam-ple, excess collateral translates into greaterlikelihood that there will be enough value torecover the entire obligation—although, obvi-ously, the creditor will never get more than theobligation amount. Subjective judgments arecritical in deciding how to stress collateral val-ues in hypothetical post-default scenarios.

How long a delay? The time it takes to real-ize the ultimate recovery is critical. In the bestcase, the recovery is highly valued due to itsnearly timely character—almost like a graceperiod. In the worst case, Standard & Poor’swould not give any credit for a very delayedpayment. In estimating the length of delay, theanalysis would focus on:

• How the legal system resolves bankrupt-cies or provides access to collateral. Thisvaries by legal jurisdiction. In the U.S., 18 to24 months is the typical time needed toresolve a Chapter 11 filing. (The analysiswould identify and differentiate cases thatmight take longer than usual because of per-ceived complexities, such as litigation.) InWestern European countries, which are gener-ally more creditor-oriented, the access to col-lateral may be expedited.

• The structure of an obligation. The analy-sis could distinguish between a bond, a leaseobligation, and certificates governed bySection 1110 of the U.S. Bankruptcy Code—which provides specific legal rights to obtaincertain transportation assets during a bank-ruptcy proceeding.

• The terms of an obligation. In the case ofa guarantee that provided for ultimate—butnot necessarily timely—payment; for example,it would be important to know within whatperiod payment must be made.

Weighting. The higher the rating, the moreone should give weight to timeliness; the lowerthe rating, the more it should incorporate apost-default perspective. (This principle is thebasis for the policy of rating junior debt ofinvestment-grade issuers one notch below theissuer rating, but differentiating junior debt ofspeculative-grade borrowers by two notches.)Therefore, the degree of enhancement general-ly depends on the starting point—the level ofthe issuer credit rating.

In those exceptional cases of high confidencein quick payment—such as ultimate guaran-tees by governments—a different approach isused: notching down from the guarantor.(Enhancement should not result in a ratingthat would equal the rating with full timeli-ness. For example, in the case of a ‘BB’ issuerand an ultimate guarantee from an ‘AA’ guar-antor, the result might be anywhere between‘BB+’ and ‘AA-,’ but definitely is capped belowthe ‘AA’ that would apply if the guaranteewere to include full timeliness—either explicit-ly or as an analytical conclusion).

The matrices that follow (see table) place theabove-mentioned factors into a systematicframework.

With respect to short-term ratings, theimportance of timeliness is paramount.Accordingly, there is no enhancement of short-term ratings based on ultimate recovery.

To reiterate, the policy of enhancing issueratings based on ultimate recovery prospectsdoes not apply unless the expected recovery is100%. Standard & Poor’s does not attemptto differentiate run-of-the-mill unsecureddebt of different issuers—although we knowthat some defaults will result in recovery of80 cents on the dollar, and others will resultin 30 cents.

Well-Secured Debt: Notching Up



Ultimate Recovery Rating Criteria Framework

Corporate Credit RatingLevel: ‘BB’, ‘B’ Within 24 months Within 6 months Within 60 daysReasonable confidence of +1 notch +1 or 2 notches +2 or 3 notchesfull recovery of principal(over 1x collateral cover, after stress)Highly confident of +2 notches +2 or 3 notches +3 or 4 notchesfull recovery of principal (over 1.25x collateral cover,after severe stress case)Highly confident of recovering +3 notches +3 or 4 notches +4 notches principal and interest(over 1.65x collateral cover,after severe stress case)

Corporate Credit RatingLevel: ‘A’, ‘BBB’ Within 24 months Within 6 months Within 60 daysReasonable confidence of +1 notch +1 notch +1 notchfull recovery of principal(over 1x collateral cover,after stress)Highly confident of full +1 notch +2 notches +2 notchesrecovery of principal (over 1.25x collateral coverafter severe stress case)Highly confident of recovering +2 notches +2 notches +2 or 3 notchesprincipal and interest(over 1.65x collateral cover,after severe case)

Both syndicated bank loans and privatelyplaced debt frequently include collateral, strongcovenants, and other features designed to pro-tect the lender against loss if a borrowerdefaults. In assigning ratings to bank loans andprivate placements, Standard & Poor's takesthese features into account when analyzing therecovery prospects of a specific loan. To theextent that a bank loan or private placement iswell-secured and contains loan-specific featuresthat other loans may lack, the likelihood of fullrecovery is enhanced, leading to the potentialfor a rating higher than the borrower's corpo-rate credit rating.

Globally, creditor rights vary greatly,depending on legal jurisdiction. Well-secureddebt of borrowers subject to the U.S.Bankruptcy Code generally receives a ratingthat is one to three notches (i.e., up to one fullcategory) higher than the corporate credit rating. Even greater weight could be given tocollateral elsewhere in the world where legaljurisdictions may be more favorable forsecured creditors. On the other hand, no consideration is given for security in manycountries such as China, where the bankruptcyprocess is virtually unpredictable.

Highly rated issuers generally are notexpected to provide much collateral or otherpost-default protection when raising funds inpublic or private debt markets. Because theprobability of their defaulting is low, post-default recovery is of little relevance. For thesereasons, it would be unusual to find debt issuesthat deserved a rating higher than the issuer'scorporate credit rating.

Determining ratingsThe starting point for assigning a bank loan

or private placement debt rating is determiningthe borrower's default risk, based on an analy-sis of the firm's business strength and financialrisk. The result is the corporate credit rating.The analysis then proceeds to the recoveryaspects of a specific debt issue.

Empirical studies point to relatively highaverage recovery rates for secured debt gener-ally. But, it is critical to analyze each situation.The high average will prove little consolationfor holders of a loan that returns relatively little. Recent experience with loans to telecomcompanies underscores how recovery rates candiverge from the overall decent performance ofthis asset class.

Standard & Poor's analyzes the issue's legalstructure and the collateral that supports eachissue. The recovery risk profile is establishedby assessing the characteristics of various assettypes used as collateral and subjecting the col-lateral values to stress analysis under differentpost-default scenarios. High collateral cover-age levels can increase confidence that assetvalues will cover the secured debt, even underadverse conditions, although, obviously,greater levels of collateral do not entitle a cred-itor to any more than the amount of the claim.

When the collateral value exceeds theamount of the claim, the creditor could receivepost-petition interest. This excess collateralvalue is referred to as an “equity cushion.”The creditor must carefully manage its legalposture to take advantage of this cushion andreceive interest—while asserting that it is stillentitled to the court's “adequate protection”of the collateral. Accordingly, rating criteriacall for recognizing the potential that a bor-rower must pay such interest, even though it isalmost impossible to accurately predict suchan outcome.

Covenants Covenants alone—in the absence of collater-

al—seldom result in superior recovery protec-tion. (In fact, a company's default risk can beheightened by covenants that place it at themercy of its bankers.) Covenants can, howev-er, play a significant role in protecting creditorsof a subsidiary of another, perhaps riskier,company; tight covenants can help prevent theborrower's assets from being removed by the

72 RATING THE ISSUE n Corporate Ratings Criteria


Bank Loan and Private Placement Rating Criteria

parent firm. Covenants may also mitigate con-cern about potential credit-harming actionsincorporated in the issuer's credit rating—if thecovenants would force the loan to be repaidbefore the issuer undertakes the action. Oneexample involved a large retailer whose corpo-rate credit rating was constrained by the compa-ny's aggressive acquisition strategy and financialpolicy. Because of well-constructed covenants, itsbank loan would have had to be repaid and refi-nanced before the company could put into effectany acquisition plans. In this example, covenantsimproved the bank loan rating. (For more oncovenants, see the box above and “‘Tight’Covenants” on page 78.)

Collateral value analysisCollateral can consist of discrete assets (such

as real estate or vehicles) that may have valueindependent of the business, or it may be theoperating assets of a business enterprise, inwhich the value is a function of the businessunit as a going concern. (Bank loans given tobelow-investment-grade issuers tend to have afirst-priority lien on substantially all of a com-pany's assets: receivables, inventory, trade-marks, patents, plants, property, equipment,and pledges of subsidiary stock. Private place-ment debt issues are more likely to be securedby one or more discrete asset types.)

Both types of collateral can enhance a credi-tor's rights and help ensure loan repayment,even though it is rare that a creditor will beable to simply foreclose and seize the collater-al to liquidate it. In the U.S. at least, a bank-ruptcy filing imposes a stay on a creditor'sright to the collateral during what is often along and tortuous reorganization process.Moreover, the bankruptcy judge often haswide discretion (although seldom exercised) tosubstitute collateral. Indeed, most large com-pany bankruptcies never result in liquidation:the company is usually reorganized. (The deci-sion of whether to reorganize is influenced bya myriad of factors, including the legal system,industry trends, the long-term viability of thebusiness, its product and market position, andregulatory or political considerations.) Theform the reorganization takes, including theresolution of creditors' claims, is the result of anegotiated process worked out before or afteran actual bankruptcy filing. Nonetheless, theoutcome for creditors is ultimately a functionof the collateral's value going into the reorga-nization process. For example, bankruptcyjudges can substitute collateral, but they mustadhere to the principle of “adequate protec-tion” by providing collateral of comparablevalue to that of the original. So, knowing thevalue of the collateral—relative to the amount

RATING THE ISSUE n Corporate Ratings Criteria 73


owed—provides an approximation of just howwell a creditor is secured.

Consequently, the bank loan analysis focus-es on determining the value of the various assettypes. If the security consists of operatingassets of a unit that will continue as a goingconcern, an enterprise value analysis is per-formed. Given the nature of the enterprisevalue methodology, this is appropriately usedonly when the default scenario can be reason-ably visualized, e.g., for highly leveraged com-panies. In these instances, the business pre-sumably continues, and the financial overex-tension leads to default when the company canno longer service its entire fixed-charge bur-den. Accordingly, the enterprise value analysiscannot be used for investment-grade compa-nies or for speculative-grade companies withconservatively leveraged balance sheets.Instead, a liquidation analysis is conducted todetermine the value of the assets that consti-tute such companies’ collateral.

The analysis method that produces the high-er asset value should be used in determiningthe bank loan rating. Generally, if the businessassets are all part of the security package,thinking of the collateral as a going concernbusiness would yield the highest values. In rarecases when a line of business is out of favor orthere are concerns about business prospects,selling individual assets can produce moremoney—so the discrete asset value methodolo-gy would be employed.

Discrete asset value analysisStandard & Poor’s has rated loans backed

by a broad range of assets, from real estate anddrilling rigs to timberlands and oil and gasreserves. Important considerations include thetype and amount of collateral, whether itsvalue can be objectively verified and is likely tohold up under various post-default scenarios,and any legal issues related to perfection andenforcement.

The analytical starting point is the assets’ cur-rent value. Market value is key, and thereforeappraisals are often required. Several methodsare used to determine the market value, includingrecent sales of comparable assets and the assets’replacement cost, adjusted to reflect their age andtechnology. Other valuation techniques includediscounting cash flow, industry norms and multi-ples of earnings and cash flow, and replacementvalue and fixed prices per unit of production (fornatural resources). Although all valuation

methodologies rely on some subjective aspects,the more objective the valuation the better. Asdescribed below, the relevant value is the value ofthe asset in a distressed scenario. Therefore, cashflows are stressed, rather than using the historicallevels of cash flow, which reflect business asusual.

Book values are typically irrelevant, but maysometimes suffice if historical price and depre-ciation policies are standardized, and depreci-ation schedules are adequate to keep bookvalue in line with market value. Two examplesof assets for which this approach has beenused are shipping containers and autos.Appraisals are usually necessary when the col-lateral is specialized, such as real estate, plants,or equipment.

The assets’ potential to retain value overtime is also critical. Therefore, collateral isjudged according to volatility, liquidity, special-purpose nature, and—perhaps mostimportant—the correlation of its value withthe health of the issuer’s business. Even assetsthat have value independent of the specificowner may still be correlated to industry ormarket factors. Because the relevant context isthe default of the assets’ owner, the analystmust be mindful that the circumstances leadingto a default might also affect the assets’ values.For example, if the borrower were a super-market chain and the collateral were its fleet oftrucks, the assets’ value would not be reducedby the company’s default. But, if the borrowerwere an offshore contract driller and the col-lateral were its fleet of vessels, there might wellbe a strong correlation between the eventsleading to the company’s default and the mar-ket value of its drilling ships. Also, if properupkeep is critical to the assets’ value, theremight be some doubt about how much main-tenance a failing company would provide. Theasset characteristics that should help determinethe stability of asset values are set forth in thechart on page 73.

Any costs that would have to be expended torealize asset values also must be taken intoaccount. These include dismantling installa-tion, transportation, foreclosure, and remar-keting costs, to name a few. On the other hand,the analysis would be based on an orderly liq-uidation scenario, rather than a fire sale.

Enterprise value analysisEnterprise value is based on investors’ pre-

sumed willingness to pay a multiple of the



firm’s cash flow at a certain point in time. Fornotching purposes, that point in time is afterthe default. The enterprise value is establishedby using a general market capitalizationapproach. The firm’s EBITDA at the hypothet-ical point of default is multiplied by a repre-sentative equity multiple. Appropriate dis-counts are applied to stress both cash flow andcapitalization rates used to determine the valueof the business.

EBITDA is projected to reflect the decline incash flow at the time the company defaults.For this analytical exercise, the analyst simu-lates default scenarios. First, a base case is con-structed that represents the minimum declinein EBITDA associated with a potential default.The scenario results in maximum cash flowconsistent with a default and, therefore, equalsthe highest value for the defaulted company.Second, an alternative scenario is proposed,under which EBITDA is reduced by 50% toreflect other possible, more stressful defaultscenarios. Additional scenarios, with differentreductions, can reflect company-specificdefault factors such as sector risk, political,regulatory, or other factors. The more negativescenario is not automatically used in the ratingdetermination; analysts must judge which sce-nario is appropriate based on the company’sindividual circumstances. For example, a bor-rower with a respectable business position buta risky financial profile would be more likelyto default (if a default occurs at all) due to itsleverage than to a decline in its businessstrength. Such an entity would be viable overthe long term if it were more appropriatelycapitalized. The base case scenario would beweighed more heavily.

By contrast, a borrower with a weak businessposition but no special financial risk would mostlikely default because of a decline in its business(failure to keep up with competition, changes intechnology, etc.). The impairment of its businessassociated with the default scenario could moreseriously affect its cash flow and market value.Accordingly, the weighting would lean towardthe downside risks.

Some companies could have a weak businessposition and a weak financial profile; theirdefault might result from a decline in business,a lack of financial flexibility, or some combi-nation thereof. In such situations, the analystwould attempt to determine the appropriatedefault scenario based on company-specificinformation and industry fundamentals.

The multiple used in the enterprise valuationmodel is derived from the cash flow multiple ofthe borrower’s peer group. This market multi-ple, too, is adjusted to incorporate the negativeeffect that a bankruptcy filing, or the threat ofone, can have on asset values. Cash flow mul-tiples, of course, change along with interestrates. For rating purposes, 5x has some empir-ical validity over the long term, as we cannotpredict interest rates at the unspecified time ofthe simulated default. Actual experience withsales of distressed companies shows the 5xmultiple to be widely applicable.

In some instances, a higher multiple mightbe warranted, for example if an industry hasunusual growth potential. But, one must becautious about arguing for a higher multiplefor a company in a very troubled situation—namely, following a bankruptcy filing. It ishard to be confident that the industry wouldstill have such positive characteristics in thatcontext. When the insolvency risk can beattributed to a cyclical problem, there might besome predictability of a post-default rebound.That should warrant using a higher multiple ofthe cash flow at a cyclical low point, which thepoint of default presumably would be.

To be conservative, any priority claims suchas product or environmental liabilities that arematerial would be deducted from the enter-prise value. Similarly, the value of other exist-ing secured debt, such as industrial revenuebonds, mortgage debt, or secured lease debt, issubtracted from the enterprise value. In someinstances, trade creditors could have a perfect-ed first-priority interest in merchandise, andthe bank creditors would have a lower-priorityclaim on inventory.

The enterprise value analysis also assumesthat any revolving portion of a bank creditfacility is fully drawn at the time of default.(This harsh assumption is not made automati-cally, though, with respect to notching downany unsecured issues.) In some cases, assumedborrowings under the rated facilities are ear-marked for acquisitions. In these instances, thedefault EBITDA levels would be adjusted forthe additional cash flow from these acquisi-tions. The effect is adequately dealt with in thebase case scenario, but adjustment is called forin the downside case. Given the likelihood thatmost acquisitions will not be totally productive,the full amount of the borrowings is not addedto EBITDA. The conservative position is to add50% of the new debt to the EBITDA figure.





Standard & Poor’s default scenario is mod-eled on EBITDA being insufficient to coverinterest expense. Several events could trigger aloss in confidence or a liquidity crisis, makingthe prediction of a default’s timing difficult.For example, problems with refinancing couldprecipitate a default. A company may not beable to meet its amortization schedule or a bul-let maturity, hastening a default. Defaults oftencoincide with principal payment dates. (Otherlarge required outlays would have a similareffect on a wobbly company. Such paymentscould be related to tax liabilities, legal judg-ments, or non-discretionary capital projects.)A company facing an exceptionally large bulletmaturity may have difficulty accessing the cap-ital markets for funds to repay the maturity,and default—even though the company’s cashflows might be higher than its ongoing debtservice needs. (This default risk would be iden-tified as an important rating factor in arrivingat the corporate credit rating.) In such a case,the cash flow associated with the default sce-nario may well be higher than the usual basecase default assumptions.

On the other hand, refinancing risk is ulti-mately related to a company’s prospects. Ifprospects for a company suggest an ongoingcapability to service its debt, this should beperceived by lenders, and financing would beavailable. The distressed EBITDA default sce-nario generally reflects conditions that pre-clude refinancing.

Companies and their bankers often assertthat the carefully crafted covenants in the loandocumentation will cause the bankers to stopadvancing funds, causing a default long beforecash flow falls as far as the model indicates.Therefore, much more value would remainwith the business, enhancing the possibility ofnotching up the bank loan rating. Yet, if thebankers are perceived as being likely to exer-cise their options (contrary to empirical evi-dence), the company’s default risk would besignificantly increased, leading to a lower cor-porate credit rating.

Stock as collateralBeing secured by a pledge of a business unit’s

stock is not the same as being secured by theassets of that unit. The stock represents onlythe residual value after all claims directlyagainst the unit have been satisfied—and mayin the end be worthless.

The criteria, however, do not precludeassigning value when shares are the collateral.Ownership confers control of a unit’s assets,even through bankruptcy proceedings. Sharesof the borrower—which would be bankrupt inthe relevant scenario—would presumably havelittle value. The same would apply to theshares of major subsidiaries of a bankrupt bor-rower, especially if the companies are in thesame general line of business. But, shares of asubsidiary in a different line of business, or ofa subsidiary in a different location that hasindependent business prospects, may retainvalue, even if that subsidiary is drawn into thebankruptcy (as long as there is no risk of sub-stantial consolidation). In such a case, the keyanalytical issue would be determining whotakes priority over the equity holders. If thatunit has few liabilities—and there are provi-sions to prevent incurring additional debt—theresidual value of the shares can be substantial.Subsidiary stock has been viewed as havingconsiderable value when assets that could notbe pledged directly (e.g., certain licenses andcontracts) were set aside in dedicated sub-sidiaries. These assets were the sole assets ofthe units, while liabilities were strictly limited.

Borrowing basesA borrowing base sets a limit on borrowing

based on a percentage of the assets outstandingat a given time. The borrowing base definitionsof eligible assets are used to exclude impairedassets such as overdue receivables or obsoleteinventory. If the analyst is comfortable withthe borrowing base formula at the outset, itsapplicability can be relied on over time. Theamount of any new borrowings would dependon the quality and value of then-current assets,although risk remains for what has alreadybeen borrowed. For example, the borrowingbase may require an amount of oil and gasreserves as collateral. But once the advance isextended, the oil is produced—and there canbe no guarantee that new oil will be found toreplace it.

Ideally, as oil is produced or inventories aresold and receivables are collected, the proceedsmust be used to repay bank borrowings, andrenewal of borrowing means once again meet-ing the tests. But often, this is not the case.Nonetheless, the proximity of the valuation tothe time of the ultimate default, as well aspotential limitation of exposure to further

deterioration are advantages. Periodic moni-toring allows the banker to exercise some con-trol. It is therefore important to know how frequently compliance with the borrowingbase is calculated and what remedies are avail-able if the base is exceeded.

The definition of eligible assets is obviouslycritical. The path to bankruptcy could involve amajor drop in asset values, even if the defaultscenario incorporates an inventory buildupresulting from a decline in sales. Unit value mayslip as inventory piles up. Accumulation ofaging, uncollectible receivables is also possible,but less common. Credit agreements often havesublimits on inventory borrowings in relation tototal borrowings to guard against just such unfa-vorable shifts in the collateral mix.

Tenor/amortizationLong-term concerns that could constrain a

corporate credit rating may extend beyond thetime horizon of an issue or bank loan facility.Therefore, a short final maturity may be favor-able. (Unsecured debt issues do not benefitsimilarly from shorter maturities because theycan be repaid only by refinancing. The issue’slong-term risk profile would affect the refi-nancing risk.)

In addition, because confidence in asset val-uations diminishes over a longer time span, theratings benefit that could be given for asset-based recovery potential is greatest for short-term loans. For example, at a given time, theoutlook for energy markets may cause little

concern for the value of oil rigs for the nexttwo or three years, but great concern aboutpotential loss of value over a 12-year period.Also, the risk of obsolescence or regulatoryrestrictions increases over time for certain typesof assets such as aircraft. Similarly, when assess-ing a potential bankruptcy scenario, doubtsabout how operating assets might be affectedwould be greater if bankruptcy proceedings areanticipated to be lengthier than normal.

Amortization reduces the amount of debtthat must be covered by the value of the assets,and thereby improves loan-to-value coverage(unless the security is reduced in tandem via aborrowing base formula). Accordingly, if onetranche of a loan facility amortizes morequickly or is significantly shorter than another,the two tranches could be rated differently.

Legal considerationsFor collateral to be given weight in the rating

process, lenders should have a perfected securi-ty interest in the collateral. Perfection can beaccomplished in a number of ways, includingUniform Commercial Code filings in the U.S.,possession, title, and regulatory filings.

Not all collateral types (e.g., patents andtrademarks) readily lend themselves to perfec-tion. And some assets, such as cargo containers,may be easy to perfect but hard to locate andrecover if they are in foreign countries at the timeof a bankruptcy filing. Uncertainty about gain-ing possession of part of the collateral can be offset by providing greater overcollateralization.



When could tight covenants enhancea company's rating?

• If the covenant breach arises from deterio-ration in the business, the bank’s enforce-ment will only compound the problem. If thebank refuses to provide more funds—andespecially if it requires repayment—the com-pany’s liquidity will suffer and the risk ofdefault increases. Best-case scenario: thebank waives or renegotiates the covenantwithout penalizing the company by way ofcompensation or tougher terms.• If the covenant breach is linked to a pro-posed credit-harming transaction that is dis-cretionary, the bank could force the compa-ny to abandon the transaction. But, if thebank waives the covenant, or if the compa-ny manages to refinance the bank loan aspart of its deal, the covenant will not havebenefited the company’s default-risk profile.Accordingly, tight covenants could theoreti-

cally benefit the corporate credit rating, but inpractical terms is quite far-fetched. Any benefitwould require the following conditions:

1. A company’s entering into a deliberatecredit-harming event would be an explicitrating factor that would preclude a higherrating (and situations in which the ratingexplicitly takes into account such an actionor event risk are uncommon), AND 2. The covenants would have to be tightenough to prevent any transaction that isinconsistent with the higher rating level, AND3. Standard & Poor’s could be confident inadvance that the bank would not waive thecovenant, AND4. The bank could not be (easily) replaced(the higher the rating, the less likely points 3or 4 would apply. The bank’s waiver oralternative financing should be available forreasonable credits. So, as long as the ratingoutcome following the transaction is ‘BB-’ orbetter, Standard & Poor’s should presumethat the deal would proceed.), AND5. Standard & Poor’s would have to be sim-

ilarly confident that the bank would refrainfrom enforcing the covenant if a company’scredit deteriorates for fundamental reasons.Otherwise, the increased risk caused bycovenant enforcement in those situationswould likely offset any rating enhancementrelated to avoiding deliberate credit-harmingtransactions. Accordingly, the rating benefitwould be restricted to situations in whichthe corporate credit rating is based largelyon the expectation of or risk of a deliberatecredit-harming action, perhaps a pendingtransaction. These situations are rare.

Would having tight covenantsenhance the bank loan rating?

If the covenant breach arises from deteriora-tion in the business, enforcement of thecovenants and precipitating a bankruptcymight indeed benefit the bank in terms of ulti-mate recovery of principal. The bank would beseeking repayment early on, with respect to thebusiness decline, while the business retainedvalue. If Standard & Poor’s were rating recov-ery prospects directly, this benefit could bemade apparent. But, current rating methodol-ogy involves notching up from the corporatecredit rating. So, the rating outcome for thebank loan with tight covenants would not nec-essarily be higher than it would be without thetight covenants—and might even be lower.Increased notching would presumably be froma lower corporate credit rating.

If the covenant breach arises from a discre-tionary transaction, the bank could avoid riskby preventing that transaction or by insistingthat it be taken out by other financing. Therating benefit, then, would still depend on theextent to which such a potential credit-harm-ing transaction plays a role as a rating factor.The more prominent the transaction’s role inthe rating—that is, to the exclusion of concernfor ordinary, fundamental risks—the more thepotential that tight covenants could mitigaterisk and enhance the assigned rating.



“Tight” Covenants

Airline and Railroad Equipment Debt

Aircraft and railroad equipment leases andsecured debt that qualify for special protectionunder Section 1110 or Section 1168, respec-tively, of the U.S. Bankruptcy Code can receiveratings above the corporate credit rating of theairline or railroad. In Canada, there is a paral-lel provision, Section 106(5) of the CanadaTransportation Act, which is very similar toSection 1168, and which is accorded similarrating treatment by Standard & Poor’s. Thesesections exclude certain types of leases andsecured debt from the automatic stay of credi-tor claims and substitution of collateral sec-tions of the code. Creditors may repossess col-lateral if the debtor does not resume debt ser-vice or lease rentals and cure any past-dueamounts within 60 days of filing for bankrupt-cy. This provides a powerful incentive for con-tinued payment under these obligations inbankruptcy.

Thus, Standard & Poor’s rating enhance-ment is based on both reduced default risk andgood ultimate recovery:

• Legal provisions that encourage continu-ing payment of interest and principal in aChapter 11 bankruptcy proceeding in order toavoid seizure of collateral (thus reducingdefault risk);

• Accelerated access to collateral if paymentis not made, under provisions of Section 1110or 1168; and

• Relatively good value retention, over longperiods of time, of aircraft and rail equipment,ease of tracking them, and the ability to realizetheir value by reselling to other operators.

Qualifications for ratingenhancement

To qualify for Section 1110 or 1168 treat-ment, creditors must have a security interest inthe equipment (for financings on assets deliv-ered before Oct. 22, 1994, this must be a pur-chase money security interest), or be a lessor,or be a conditional vendor. For Section 1110,collateral must be aircraft or aircraft parts, and

the debtor must be an airline. For Section1168, collateral must be locomotives, rollingstock, or accessories (such as autoracks) andthe debtor a railroad. Note that creditors ofleasing companies which own such equipmentcould not claim Section 1110 or 1168 protec-tions, nor could creditors of the holdingcompanies that own airlines or railroads.

Standard & Poor’s accords the maximumpossible rating enhancement (see Degree ofEnhancement) only in those cases where anairline’s size and market position make liqui-dation unlikely, allowing for a reasonable pos-sibility that aircraft financing will be paid atthe contracted rate. Railroads must file underspecial provisions of Chapter 11 of the U.S.Bankruptcy Code, and cannot file underChapter 7 (which provides for liquidation).The bankruptcy court can order liquidation,but only if a reorganization plan has not beenapproved by five years following the filing.During the reorganization process, which usu-ally takes several years, the railroad continuesto operate. Since equipment is vital for railoperations, debtholders with equipment oblig-ations can be more confident of payment thanother creditors. After the reorganizationprocess is completed, the emerging firm typi-cally continues to use its predecessor’s equip-ment and assumes most or all outstandingsecured debt obligations. Collateral which istechnologically or economically less desirableor which does not cover outstanding secureddebt by a comfortable margin would also notqualify for the rating enhancement; a bankruptairline or railroad might well allow such equip-ment to be repossessed rather than continuedebt service.

Legal opinions neededAn issuer seeking a rating on aircraft or rail

equipment financings must provide severallegal opinions to support the case for Section1110 or 1168 status:



• An opinion that creditors will enjoy thebenefits of Section 1110 or 1168 protection inthe event of bankruptcy;

• An opinion that creditors have a first pri-ority perfected security interest in the equip-ment being financed and payments being madeby the airline or railroad under the relatedlease, if any, and that the relevant documentshave been filed with the Federal AviationAdministration or the Surface TransportationBoard (both entities of the U.S. Department ofTransportation), respectively.

• Where the lessor of the equipment to the air-line is a trust, opinions bearing on nonconsolida-tion of the assets in the trust, of which the ownerparticipant is a beneficiary, with the estate of theowner participant in bankruptcy. This opinionaddresses the risk that cash payments from thelessee to the debtholder may be delayed or divert-ed due to the owner participant’s bankruptcy.

• For pass-through certificates, an opinionon the valid formation of the pass-throughentity, and that the pass-through trust does notconstitute an investment company as definedin the Investment Company Act of 1940, andis not subject to federal or state taxation.

• For railroads, an opinion that common car-rier railroad equipment obligations are issuedunder an exemption from registration with theSecurities & Exchange Commission afforded bySection 3(a)(6) of the Securities Act of 1933,and that prior approval of the issuance by stateregulators should not be required.

Degree of enhancementThe degree of enhancement applied by

Standard & Poor’s depends on the above fac-tors and the issuer’s corporate credit rating.For airlines, investment-grade issuers receive aone “notch” upgrade (e.g., ‘A-’ to ‘A’), whilespeculative-grade airlines would typicallyreceive a two-notch enhancement (e.g., ‘B’ to‘BB-’). Rail equipment obligations are typical-ly rated one full category above that of thecompany’s corporate credit rating, but in mostcases no lower than ‘BBB-’. The potential rat-ing enhancement for Section 1168 is greaterthan that accorded to airlines, which enjoylegally similar protection under Section 1110of the Bankruptcy Code. The reasons for thisdifference and the factors that support creditquality of railroad equipment trust certificatesare explained below.

• As noted above, railroads cannot, bystatute, enter Chapter 7 liquidation proceed-

ings. Liquidation under Chapter 11 has histor-ically been rare, although partial deregulationof the industry makes that outcome more con-ceivable than in the past.

• A trustee always is appointed to oversee arailroad reorganization, and, as such, is explic-itly charged with considering “the public inter-est” in addition to those of other parties. Inpractice, this means maintaining service when-ever possible.

• Railroads, with their proprietary rights ofway, are often the only practical means ofdelivering bulk commodities (such as coal,grain, and chemicals) to certain shippers andcustomers. Congress and the regulatory bodies(historically, the Interstate CommerceCommission [ICC]; since January 1, 1996, theSurface Transportation Board of the U.S.Department of Transportation) tend to place apremium on maintaining service, whichimplies keeping equipment.

• Equipment debt and leases represent asmaller proportion of total obligations thanfor airlines, and supply and demand for rail-road equipment tends to stay in better balancethan for aircraft. Consequently, continued debtservice in reorganization is less burdensomefor railroads than is sometimes the case for air-lines.

• Railroad equipment is typically financed ingroups, because the cost of individual units($1.5 million to $2.0 million for a locomotive,$40,000 to $60,000 for a typical railcar) makeseparate transactions uneconomical. A trusteewould have to reject the whole pool to escapedebt service, in contrast to airlines, which canreject leases on individual aircraft that nolonger meet their needs.

At the point an airline or railroad is inChapter 11 bankruptcy proceedings and non-equipment senior obligations are typically indefault, its corporate credit rating is “N.M.”(“not meaningful”). The rating on Section1110 or 1168 obligations would be based onStandard & Poor’s estimate of the likelihoodof a successful reorganization and the particu-lar features of the equipment financing underconsideration. For airlines, such a ratingwould typically be in the ‘CCC’ category, butmight fall into the ‘B’ category if the financingin question is very well secured and/or hasbeen affirmed by the court and the airlineseems likely to reorganize successfully. For rail-roads, a rating in the ‘B’ category or even ‘BB’categories would be more likely.



Commercial paper consists of unsecuredpromissory notes issued to raise short-termfunds. Typically, only companies of strongcredit standing can sell their paper in themoney market, although there was someissuance of lesser-quality, unrated paper priorto the junk bond market collapse late in 1989.(Alternatively, companies sell commercialpaper backed by letters of credit (LOC) frombanks. Credit quality of such paper restsentirely on the transaction’s legal structure andthe bank’s creditworthiness. As long as theLOC is structured correctly, credit quality ofthe direct obligor can be ignored.)

Rating criteriaEvaluation of an issuer’s commercial paper

(CP) reflects Standard & Poor’s opinion of theissuer’s fundamental credit quality. The analyt-ical approach is virtually identical to the onefollowed in assigning a long-term corporatecredit rating, and there is a strong link betweenthe short-term and long-term rating systems(see chart). Indeed, the time horizon for CPratings extends well beyond the typical 30-daylife of a CP note, the 270-day maximum matu-rity for the most common type of CP in theU.S., or even the one-year tenor used to distin-guish between short-term and long-term rat-ings in most markets. CP ratings are intendedto endure over time, rather than changefrequently.

In effect, to achieve an ‘A-1+’ CP rating thefirm’s credit quality must be at least the equiv-alent of an ‘A+’ long-term corporate credit rat-ing. Similarly, for CP to be rated ‘A-1’, thelong-term corporate credit rating would needto be at least ‘A-’. (In fact, the ‘A+’/‘A-1+’ and‘A-’/‘A-1’ combinations are rare. Typically, ‘A-1’ CP ratings are associated with ‘A+’ and ‘A’long-term ratings.)

Conversely, knowing the long-term ratingwill not fully determine a CP rating, consider-ing the overlap in rating categories. However,the range of possibilities is always narrow. To

the extent that one of two CP ratings might beassigned at a given level of long-term creditquality (e.g., if the long-term rating is ‘A’),overall strength of the credit within the ratingcategory is the main consideration. For exam-ple, a marginal ‘A’ credit likely would have itsCP rated ‘A-2’, whereas a solid ‘A’ wouldalmost automatically receive an ‘A-1’.

Occasionally, the CP rating may focus moreintensely on the nearer term. For example, acompany may possess substantial liquidity—providing protection in the near or intermedi-ate term—but suffer from less-than-stellarprofitability, a longer-term factor. Or, therecould be a concern that, over time, the largecash holdings may be used to fund acquisi-tions. Conversely, following a major acquisi-tion, confidence that the firm can restorefinancial health over the next couple of years


n STANDARD & POOR’Sn STANDARD & POOR’Sn STANDARD & POOR’Sn STANDARD & POOR’S

CORRELATION OF CP RATINGS WITH LONG-TERM CORPORATE CREDIT RATINGS*

* Dotted lines indicate combinations that are highly unusual.See text.

Commercial Paper



may be factored into its long-term ratings,while the financial stress that dominates thenear term may lead to a relatively low CP rat-ing. Having different time horizons as the basisfor long- and short-term ratings implies thateither one or the other rating is expected tochange.

Backup policiesEver since the Penn Central bankruptcy

roiled the commercial-paper market and somecompanies found themselves excluded fromissuing new commercial paper, Standard &Poor’s has deemed it prudent for companiesthat issue commercial paper to make arrange-ments in advance for alternative sources of liq-uidity. This alternative, “backup” liquidityprotects them from defaulting were theyunable to roll over their maturing paper withnew notes—due to a shrinkage in the overallcommercial-paper market or some cloud overthe company that might make commercial-paper investors nervous. Many developmentsaffecting a single company or group of compa-nies—including bad business conditions, alawsuit, management changes, a ratingchange—could make CP investors flee thecredit.

(Given the size of the CP market, backupfacilities could not be relied on with a highdegree of confidence in the event of wide-spread disruption. A general disruption of CPmarkets could be a highly volatile scenario,under which most bank lines would representunreliable claims on whatever cash would bemade available through the banking system tosupport the market. Standard & Poor’s neitheranticipates that such a scenario is likely todevelop, nor assumes that it never will.)

Having inadequate backup liquidity affectsboth the short- and long-term ratings of theissuer because it could lead to default, whichwould ultimately pertain to all of the company’sdebt. Moreover, the need for backup applies toall confidence-sensitive obligations—not justrated CP. Backup for 100% of rated CP ismeaningless if other debt maturities—for whichthere is no backup—coincide with those of CP.Thus, the scope of backup must extend to EuroCP, master notes, and short-term bank notes.

The standard for industrial and utilityissuers has long been 100% coverage of confi-dence-sensitive paper for all but the strongestcredits. Backup is provided by excess liquid

assets or bank facilities in an amount thatequals all such paper outstanding.

(While the backup requirement relates onlyto outstanding paper—as opposed to the entireprogram authorization—a firm should antici-pate prospective needs. For example, it mayhave upcoming maturities of long-term debtthat it may want to refinance with commercialpaper, which would then call for backup ofgreater amounts.)

Available cash or marketable securities areideal to provide backup. (Of course, it may benecessary to “haircut” their apparent value toaccount for potential fluctuation in value ortollgate taxes surrounding a sale. And it is crit-ical that they be immediately saleable.) Yet thevast majority of commercial paper issuers relyon bank facilities for alternative liquidity.

(This high standard has provided a sense ofsecurity to the commercial-paper market–eventhough backup facilities are far from a guaran-tee that liquidity will, in the end, be available.For example, a company could be denied fundsif its banks invoked “material adverse change”clauses. Alternatively, a company in troublemight draw down its credit line to fund othercash needs, leaving less-than-full coverage ofpaper outstanding, or issue paper beyond theexpiration date of its lines.)

Companies rated ‘A-1+’ can provide 50%-75% coverage The exact amount is determinedby the issuer’s overall credit strength and itsaccess to capital markets. Current credit qual-ity is an important consideration in tworespects: It indicates:

1) The different likelihood of the issuer’sever losing access to funding in the commer-cial-paper market; and

2) The time frame presumed necessary toarrange funding should the company loseaccess. A higher-rated entity is less likely toencounter business reverses of significanceand—in the event of a general contraction ofthe commercial-paper market—the higher-rated credit would be less likely to loseinvestors. In fact, higher-rated firms couldactually be net beneficiaries of a flight toquality.

In 1999, Standard & Poor’s introduced anew approach that offers companies a secondoption. Under the new criteria, companieshave greater flexibility with respect to theamount of backup they maintain—if they areprepared to match their maturities carefully



with available liquidity. The new criteria focusexplicitly on a company’s maturity schedule,thereby differentiating between companies thatare rolling over all their commercial paper injust a few days and those that have a cushionby virtue of having placed longer-dated paper.

The basic idea is that firms—if and whenthey lose access to commercial paper—shouldhave sufficient liquidity to cover any papercoming due during the time they would requireto arrange additional funding. How longmight that take? Again, a key assumption isthat companies of better credit quality will beable to arrange funding more quickly.Accordingly, companies currently rated ‘A-1+’or ‘A-1’ are presumed to remain reasonablygood credits—even if they should experience aliquidity problem—and should be able toarrange funding within 30 days. For compa-nies that are rated only ‘A-2’, the presumedperiod is longer, 90 days; as weaker credits,they would find it more difficult to arrangefinancing. For ‘A-3’ rated companies, coverageshould be 100% of outstanding amounts, nomatter what the maturity profile.

It is critical to consider the upcoming matu-rities on a rolling basis—rather than to rely onaverages—because borrowing patterns vary ascompanies finance peak needs or occasionallybunch maturities. The backup must alwayscover the peaks—as they fall within the num-ber of days to be covered. The issuer has toperform a daily exercise of matching the max-imum amount of paper maturing in theupcoming 30- or 90-day periods (dependingon its rating) with backup liquidity thatincludes excess cash, bank lines, capital-market commitments, and so forth. The matu-rities to be matched include commercial paper,euro CP, master notes, and short-term notes,

as well as current maturities of long-term debtand medium-term notes that the company isplanning to refinance with commercial paperor short-term notes.

All issuers—even if they provide 100%backup—must always match the first few daysof maturities with excess cash or funding facil-ities that provide for immediate availability.For example, a bank backup facility thatrequires two-day notification to draw downwon’t be of any use in repaying paper matur-ing in the interim. The same would hold true ifforeign exchange is needed—and the facilityrequires a couple of days to provide it.Moreover, if a company issuing commercialpaper in the U.S. were relying on a bank facil-ity in Europe, differences in time zones or bankholidays could prevent availability when need-ed. Obviously, a bank facility in the U.S. wouldbe equally lacking with respect to maturingeuro CP. So-called “swing lines” typicallyequal 15%-20% of the program size in orderto deal with the maximum amount that willmature in any three- to four-day period.

Extendible commercial notes (ECN) provide“built-in backup” by allowing the issuer toextend for several months if there is difficultyin rolling over the notes. Accordingly, there isno need to provide backup for them. However,there is no way to prevent the issuer from tap-ping backup facilities intended for other debtand use the funds to repay maturing ECNs—instead of extending. This risk is known as“leakage.” Accordingly, for issuers that pro-vide 100% backup, unbacked ECNs must notexceed 20% of extant backup for outstandingconventional commercial paper. Companiesproviding backup based on upcoming maturi-ty levels could not issue ECNs without backupbecause that would degrade their coveragebelow what is deemed a minimum level.

Quality of backup facilitiesBanks offer various types of credit facilities

that differ widely regarding the degree of thebank’s commitment to advance cash under allcircumstances. Weaker forms of commitment,while less costly to issuers, provide banks greatflexibility to redirect credit at their own discre-tion. Some lines are little more than an invita-tion to do business at some future date.

Standard & Poor’s expects that all backuplines be in place and confirmed in writing.“Preapproved” lines or orally committed lines

Guidelines for U.S. industrials and utilities

Traditional New approachapproach (days of (% of total upcomingoutstanding) maturing paper)

A-1+/AAA 50% 30 daysA-1+/AA 75% 30 daysA-1 100% 30 daysA-2 100% 90 daysA-3 100% All paper

outstanding

are viewed as insufficient. Specific designationfor CP backup is of little significance.

Contractually committed facilities are desir-able. In the U.S., fully documented revolvingcredits represent such contractual commit-ments. Standard & Poor’s considers it prudentfor ‘A-1’ and ‘A-2’—and certainly ‘A-3’—CPissuers to have a substantial portion of theirbackup in the form of a contractually commit-ted facilities. (The weaker the credit, thegreater the need for more reliable forms of liq-uidity.) As a general guideline, if contractuallycommitted facilities cover 10-15 days’ upcom-ing maturities of outstanding paper, thatshould suffice.

(Even contractual commitments ofteninclude “material adverse change” clauses,allowing the bank to withdraw under certaincircumstances. While inclusion of such anescape clause weakens the commitment,Standard & Poor’s does not consider it criti-cal—or realistic—for most borrowers to nego-tiate removal of “material adverse change”clauses.)

In the absence of a contractual commitment,payment for the facility—whether by fee or bal-ances—is important because it generally createssome degree of moral commitment on the partof the bank. In fact, a solid business relation-ship is key to whether a bank will stand by itsclient. Standardized criteria cannot capture orassess the strength of such relationships.Standard & Poor’s is interested, therefore, inany evidence—subjective as it may be—thatmight demonstrate the strength of an issuer’sbanking relationships. In this respect, the ana-lyst is also mindful of the business cultures indifferent parts of the world and their impact onbanking relationships and commitments.

Dependence on just one or few banks is alsoviewed as an unwarranted risk. Apart from thepotential that the bank will not have adequatecapacity to lend, there is the chance that it willnot be willing to lend to this issuer. Havingseveral banking relationships diversifies therisk that any bank will lose confidence in thisborrower and hesitate to provide funds.

Concentration of banking facilities alsotends to increase the dollar amount of an indi-vidual bank’s participation. As the dollaramount of the exposure becomes large, thebank may be more reluctant to step up to itscommitment. In addition, the potentialrequirement of higher-level authorizations atthe bank could create logistical problems with

respect to expeditious access to funds for theissuer. On the other hand, a company will notbenefit if it spreads its banking business sothinly that it lacks a substantial relationshipwith any of its banks.

There is no analytical distinction to be madebetween a 364-day and a 365-day facility!Even multiyear facilities will provide commit-ment for only a short time as they approachthe end of their terms. However, it is obvious-ly critical that the company arrange for thecontinuation of its banking facilities well inadvance of their lapsing.

It is important to reiterate that even thestrongest form of backup—a revolver with no“material adverse change” clause—does notenhance the underlying credit and does notlead to a higher rating than indicated by thecompany’s own creditworthiness. Creditenhancement can be accomplished onlythrough an LOC or another instrument thatunconditionally transfers the debt obligationto a higher-rated entity.

Banks providing issuers with facilities forbackup liquidity should themselves be sound.Possession of an investment-grade rating indi-cates sufficient financial strength for the pur-pose of providing a CP issuer with a reliablesource of funding. There is no requirementthat the bank’s credit rating equal the issuer’srating. Nonetheless, Standard & Poor’s wouldlook askance at situations where most of acompany’s banks were only marginally invest-ment grade. That would indicate an imprudentreliance on banks that might deteriorate toweaker, non-investment-grade status.

Recent InnovationsApart from ECNs, several new forms of

backup have been designed recently.Companies are keen to utilize these new prod-ucts to diversify their sources of alternative liq-uidity and also to reduce their reliance on thecommercial-banking sector.

Typically, a structured entity is created toprovide commitments to commercial paperissuers. The entity may obtain its funding fromcommercial banks, insurance companies,mutual funds, small investors, or even from thecommercial paper market itself. The fundsmay be raised in advance—or lined up via con-tract. A banking firm may provide a short-term commitment to create immediate avail-ability, “bridging” the time it takes to accessthe funds from the capital markets. Such enti-





ties can “leverage” their funding capacity—making commitments in an amount that is amultiple of their funding capacity—based onthe premise that not all the commitments willbe exercised—at least, not all at the same time.

(Standard & Poor’s analyzes the extent towhich a given structure can prudently makecommitments in excess of its funding limits.The determining factors include: diversifica-tion of companies to which commitments aremade; the credit quality of those companies;the duration of the commitment; and how longthe companies would retain the advances,which may be determined by the terms ofrepayment. Standard & Poor’s would issue aletter stating that the entity’s commitments areacceptable as commercial paper backup, ormight assign a rating to the entity—much likea counterparty rating—indicating the qualityof its commitment.)

With the advent of nonbank backup andECNs, it is necessary to consider how a com-pany might manage to remain solvent after uti-lizing the backup arrangement to repay orextend its maturing commercial paper. Theextension of an ECN, for example, merely pro-vides the company a breather; the companymust still procure new funding to pay off thenote. The extended note represents a hardmaturity, as opposed to the expiration of abank facility, because a bank facility presum-ably would be renewed in a normal lendingrelationship. Similarly, backup provided bystructured vehicles or capital-market contractswould pay off the outstanding commercialpaper—but leave the company still facing hardmaturities.

The common analytical element for deter-mining how long a breather is required whenthe backup facility provides only a temporaryrespite—and how much backup is needed inthe first place—is the pragmatic question:How much time might a company need toarrange more permanent funding? However,the tenor of backup facilities is relevant only ina scenario where the company already has lostaccess to the commercial paper market!Accordingly, Standard & Poor’s feels that thetenor of any backup facility with a hard matu-rity needs to be at least 90 days. The ratinglevel of the company while it is still issuingcommercial paper is not a consideration.

DOCUMENTATION FOR COMMERCIAL PAPER PROGRAM RATINGS

—Company letter requesting rating—Copy of board authorization for program—Indication of authorized amount—Indication of program type (e.g., 3(A)3,

4(2), ECN, euro)—Description of use of proceeds—Listing of dealers (unless company is a

direct issuer)—Description of backup liquidity (including

list of bank lines, giving the terms of the facilities, the name of each bank participating, commitment amount, and form of the commitment).

Preferred Stock



Preferred stock carries greater credit riskthan debt in two important ways: The dividendis at the discretion of the issuer and the pre-ferred represents a subordinated claim in theevent of bankruptcy. Accordingly, preferred isgenerally rated below subordinated debt. Whenthe firm’s corporate credit rating (CCR) is invest-ment grade, its preferred stock is rated twonotches below the CCR. For example, if theCCR is ‘A+’, preferred stock would be rated ‘A-’.(In case of a CCR of ‘AAA’, preferred would berated ‘AA+’.) When the CCR is non-investmentgrade, preferred stock is rated at least threenotches (one rating category) below the CCR.Deferrable payment debt is treated identicallyto preferred stock, given subordination and theright to defer payments of interest.

Financial instruments that have one of thesecharacteristics—but not both (for example,deferrable debt with a senior claim) are gener-ally rated one notch below the CCR for invest-ment grade credits, and two notches below theCCR for speculative grade credits.

When there is an unusual reliance on pre-ferred stock, there is greater risk to the divi-dend. If preferred issues total over 20% of thefirm’s capitalization, that normally would callfor greater differentiation from the CCR.There are other situations where the dividendis jeopardized, so notching would exceed theguidelines above. For example, state chartersrestrict payment when there is a deficit in theequity account. This can occur following awrite-off, even while the firm is healthy andpossesses ample cash to continue paying.Similarly, covenants in debt instruments canendanger payment of dividends—even whilethere is a capacity to pay.

Subordination of an instrument is a ratingconsideration no matter the degree of the sub-ordination. Standard & Poor’s does not ordi-narily make a distinction for deep subordina-tion, i.e., the fact that preferred stock is juniorto other subordinated issues.

The risk of deferral of payments is analyzedfrom a pragmatic, rather than a legal, perspec-tive. In some instances, the right to defer isconstrained by virtue of financial covenants. Inothers, the discretion to defer is limited by theremedy that preferred holders possess to takeover the issuing entity and liquidate its assets.Note, though, that such situations are excep-tional and normally pertain to negotiated, pri-vately placed transactions. Yet there do exist ahandful of preferred issues that are rated paripassu with the company’s debt ( in some cases,senior debt).

If a company defers a payment or passes ona preferred dividend, that is tantamount todefault on the preferred issues. The rating ischanged to ‘D’ once the payment date haspassed. The rating would usually be lowered to‘C’ in the interim, if nonpayment were pre-dictable—for example, if the company were toannounce that its directors failed to declare thepreferred dividend. Whenever a companyresumes paying preferred dividends butremains in arrears with respect to payments itskipped, the rating is, by definition, ‘C’. (Seepage 24 for a discussion of how different typesof preferred stock affect a firm’s overall credit-worthiness.)

Convertible PreferredSecurities such as PERCS and DECS/PRIDES

provide for mandatory conversion into com-mon stock of the company. Such securitiesvary with respect to the formula for sharingpotential appreciation in share value. In theinterim, these securities represent a preferredstock claim. Other offerings package a short-life preferred stock with a deferred commonstock purchase contract to achieve similareconomics.

These issues are viewed very positively interms of equity credit—that is, if conversionwill take place in a relatively short time frameand the imbedded floor price of the shares



makes it unlikely that the firm will regret itsdecision to sell new common.

Ratings on the issue address only the likeli-hood of interim payments and the solvency ofthe firm at the time of conversion to enable itto honor its obligation to deliver the shares.These ratings do not address the amount orvalue of the common equity that the investorwill ultimately receive. Standard & Poor’shighlights this risk by appending an “r” to theratings of these hybrid securities.

Trust preferred stockWhen using a trust preferred, a company

establishes a trust that is the legal issuing enti-ty of the preferred stock. The sale proceeds ofthe preferred are lent to the parent company,and the payments on this intercompany loanare the source for servicing the preferred oblig-ation. In some cases, this financing structurecan provide favorable equity treatment for thecompany, even while the payments enjoy tax-deductibility.

Standard & Poor’s rating of trust preferredsis based on the creditworthiness of the parentcompany and the terms of the intercompanyloan. Any equity credit that might be associat-

ed with these issues also is a function of theterms of the intercompany loan, especiallywith respect to payment flexibility.

This variety of preferred was introduced in1995 as TOPrS—Trust Originated PreferredSecurities. TOPrS represented a structuralalternative for deferrable payment hybrids thathad been sold since late 1993 under the appel-lation MIPS—Monthly Income PreferredSecurities.

The use of a trust neither enhances nordetracts from the structure compared to thealternative issuing entities. The legal form ofthe issuing entity can be a business trust, limit-ed partnership, off-shore subsidiary in a taxhaven, or on-shore limited liability corpora -tion. What these structures have in common isan intercompany loan with deferral features(typically five years), no cross-default provi-sion, a long maturity, and deep subordination.The preferred dividend is similarly deferrable,as long as common dividends are not beingpaid. After the deferral period, the trust pre-ferred holders have legally enforceable credi-tors rights—in contrast to conventional pre-ferreds, which provide only very limited rights.

Criteria Topics

Standard & Poor’s is regularly asked “Willthe issuer of this hybrid security receive ‘equi-ty credit’?” In other words, has the issuer’scredit quality improved and has its debt capac-ity expanded, as is ordinarily the case whenequity is added to the balance sheet?

The question of “equity credit” is not ayes/no proposition. The notion of “partialcredit” is very appropriate. When it comes tocalculating ratios, a hybrid security may beviewed as debt in some respects and as equityin other respects.

What is equity?What constitutes equity in the first place?

Traditional common stock—the paradigmequity—sets the standard. But equity is not amonolithic concept; rather, it has severaldimensions. Standard & Poor’s looks for thefollowing positive characteristics in equity:

• It requires no ongoing payments that couldlead to default;• It has no maturity or repayment requirement;• It provides a cushion for creditors in the caseof a bankruptcy; and• It is expected to remain as a permanent fea-ture of the enterprise’s capital structure.If equity has these distinct defining attributes,

it should be apparent that a specific security canhave a mixed impact. For example, hybrid secu-rities, by their very nature, will be equity-like insome respects and debt-like in others. Standard& Poor’s analyzes the specific features of anyfinancing to determine the extent of financialrisks and benefits that apply to an issuer.

In any event, the security’s perceived eco-nomic impact is relevant, its nomenclature isnot. A transaction that is labeled debt foraccounting, tax, or regulatory purposes maystill be viewed as equity for rating purposes,and vice versa.

Attributes of equityEquity provides value for the enterprise.

When a company sells equity, it receives

money to invest in its business. It is able to doresearch, buy equipment, or support inventoryand receivables growth—all to generate cashflow and keep the enterprise healthy. If issuinga security allows the company to avoid a cashoutflow that would have been incurred in thecourse of business, the beneficial impact isidentical. When shares are issued in lieu ofemployee benefits that otherwise would bepaid in cash, for example, as part of an ESOP,this aspect of equity is fulfilled. However, ifshares are issued as a new—perhaps unneces-sary—form of compensation, the benefit isdubious: Has the enterprise received anythingof value?

Soft capital, a commitment from a nonaffili-ated provider of capital to inject equity capitalat a later date, offers another example of atransaction that falls short in terms of thisbasic attribute of equity. However valuable itmay be to have a call on funds in the future,the business does not have the funds now.Also, by making the funds available at thecompany’s discretion, there is the risk that adelay in the firm’s exercising of its option maylead to a situation of “too little, too late.”

Equity requires no ongoing payments thatcould lead to default.

Equity pays dividends, but has no fixedrequirements that could lead to default andbankruptcy if these dividends are not paid.Moreover, there are no fixed charges thatmight, over time, drain the company of fundsthat may be needed to bolster operations. Acompany is under pressure to pay both pre-ferred and common dividends, but ultimatelyretains the discretion to eliminate or defer pay-ment when it faces a shortage of funds. Ofcourse, a firm’s reluctance to pass on a pre-ferred dividend is not identical to its reticenceto altering its common payout. Accordingly,there is a difference in “equity credit” affordedto common equity relative to preferred equity.

The longer a company can defer dividendsthe better. An open-ended ability to defer until

CRITERIA TOPICS n Corporate Ratings Criteria 91

Equity Credit: What Is It and How Do You Get It?

n STANDARD & POOR’Sn STANDARD & POOR’S

92 CRITERIA TOPICS n Corporate Ratings Criteria


financial health is restored is best. As a practi-cal matter, the ability to defer dividend pay-ments for five or six years is most critical inhelping to prevent default. If the company can-not restore financial health in five years, itprobably never will. The ability to defer pay-ments for shorter periods is also valuable, butequity content diminishes quickly as con-straints on the company’s discretion increase.

Debt instruments can be devised to provideflexibility with regard to debt service.Deferrable payment debt issued directly toinvestors—that is, without a trust structure—legally affords the company flexibility regard-ing the timing of payments that is analogous totrust preferreds. Yet, by being identified as a“debt security,” the company’s practical dis-cretion to defer payments may be constrained,which diminishes the equity credit attributedto such hybrids vs. deferrable paymentpreferred stock.

Income bonds, i.e., where the payment ofinterest is contingent on achieving a certainlevel of earnings, were designed with this inmind. However, to the extent that cash flowdiverges from earnings measures, incomebonds tend to be imperfect instruments. Arecent variation on the theme is the cash flowbond, which pegs the level of interest paymentsto the firm’s cash flow. The equity content ofsuch instruments is a function of the thresholdlevels used to determine when payments arediminished. If the level of cash flow that trig-gers payment curtailment is relatively low, thatinstrument is not supportive of high ratings.

Another straightforward concept entailslinking interest payments to the company’sdividend, creating an equity-mimicking bond.A number of international financial institu-tions issued such bonds in the late 1980s.

Equity has no maturity or repaymentrequirement.

Obviously, the ability to retain the funds inperpetuity offers the firm the greatest flexibili-ty. Extremely long maturities are next best.Accordingly, 100-year bonds possess an equityfeature in this respect (and only in this onerespect) until they get much nearer their matu-rity. To illustrate the point, consider howmuch, or how little, the company would haveto set aside today to defease or handle theeventual maturity. However, cross-defaultprovisions would lead to these bonds beingaccelerated.

Preferred equity often comes with a maturi-ty, as a limited life or sinking fund preferred,which would constitute a clear shortcoming interms of this aspect of equity. Limited creditwould be given for this type of preferred, evenif the security had a 10-year life or more. Evenif it could be assumed that the issue is success-fully refinanced at maturity, the potential forusing debt in the refinancing would be a con-cern (see following discussion on permanenceof equity).

Equity provides a cushion for creditors inthe event of default.

What happens in bankruptcy also pertainsto the risk of default, albeit indirectly.Companies can continue to raise debt capitalonly as long as the providers feel secure aboutthe ultimate recovery of their loans in the eventof a default. Debtholders’ claims have priorityin bankruptcy, while equity holders are rele-gated to a residual claim on the assets. Theprotective cushion created by such equity sub-ordination allows the company access to capi-tal, enabling it to stave off a default in the firstplace.

Flexible payment bonds, of course, wouldnot qualify on this aspect of equity. Similarly,convertible debt—even mandatorily convert-ible debt—would not be much help in thisregard if the issuer were vulnerable to defaultduring the interim period prior to conversion.

Equity is expected to remain a permanentfeature of the enterprise’s capital structure.

At any time, a company can choose either torepurchase equity or to issue additional shares.However, some securities are more prone tobeing temporary than others. Standard &Poor’s analysis tries to be pragmatic, lookingfor insights as to what may ultimately occur.

Preferred stock, in particular, is likely tohave provisions for redemption or exchange, ifnot an outright stated maturity. Auction orremarketed preferred stock is designed for easyredemption. Even though the terms of this typeof preferred provide for its being perpetual,failed auctions or lowered ratings typicallyprompt the issuer to repurchase the shares.

Standard & Poor’s discussions with man-agement regarding the firm’s financial policiesprovide insights into the company’s plans forthe securities: whether a company will call orrepurchase an issue and what is likely toreplace it. Another important consideration isthe issuer’s tax-paying posture. It is difficult

for a non-taxpaying issuer to make the casethat the firm will continue to finance withnon-tax-deductible preferred stock once itbecomes a taxpayer and can lower its cost ofcapital by replacing the preferred with debt.Other clues can come from the nature ofinvestors in the issue (e.g., money market vs.long-term fixed-income investors) and themode of financing that is typical of the com-pany’s peer group. For example, utilities tradi-tionally finance with preferred stock, andindustry regulators are comfortable with it.Therefore, the usual concern that limited-lifepreferred stock will be refinanced with debtdoes not generally apply in the case of utilities.In the case of so-called “tax-deductible” pre-ferreds, the issues are different. The risk hereis that their favorable tax status is overturned.Especially with regard to new hybrids, thatrisk may be substantial. This concern can bemitigated by provisions in the transaction toconvert into another equity-like security in theevent of loss of tax-deductibility.

Rating methodologyWhile many people focus on the leverage

ratio in thinking about equity credit, a compa-ny’s leverage is just one of many componentsof a rating assessment. (In fact, cash flow ade-quacy and financial flexibility have long sur-passed balance-sheet considerations as impor-tant rating factors.) Standard & Poor’smethodology of breaking all the analyses intocategories allows each of the several attributesof hybrid securities to be considered separate-ly and in the appropriate analytical category.

The aspect of ongoing payments is consideredin fixed-charge coverage and cash-flow adequa-cy; equity cushion in leverage and asset protec-tion; need to refinance upon maturity in finan-cial flexibility; and potential for conversion in

financial policy. The before-tax and after-taxcost of paying for the funds is also a componentof both earnings and cash flow analysis.

There is no uniform weighting of the analyt-ical categories to arrive at a rating conclusion.Accordingly, the relative importance of eachequity attribute can vary. The critical issues forcompanies can differ. Moreover, the factorsthat delineate an ‘A’ from an ‘AA’ rating tendto differ from those factors that determinewhether a rating will be ‘B’ or ‘BB’. Similarly,the impact of a hybrid may depend on the spe-cific needs of a given issuer or its place in therating spectrum. Aspects affecting near-termflexibility are usually of prime importance forlow-rated, troubled credits, while long-termconsiderations are more germane when analready highly rated credit is being reviewedfor an upgrade. To illustrate the point:Replacing 20-year debt with 100-year debt is anonevent for a company that faces insolvencyin the next several quarters.

Standard & Poor’s does not simply “hair-cut” hybrid securities or assign fractional“equity credit” when calculating financialratios. There is just no tidy way to adjustfinancial ratios to reflect the nuances of com-plex structures. Sometimes, the analyst calcu-lates alternative sets of ratios, reflecting thatthe “truth” lies in a gray area between twoperspectives.

There are no specific limitations with respectto the amount of hybrid preferred that receivesequity treatment. However, at some point, onewould question a company’s creating a capitalstructure with an unusually large proportionof newfangled securities. The analytical com-fort range depends on the seasoning of the typeof instrument, peer group comparisons, andany potential negatives for the firm that mightprompt it to reevaluate and restructure.





There are many ways to arrange for the cre-ation of equity in the future. These methodsrange from issuing traditional convertiblesecurities to entering forward purchase con-tracts to establishing grantor trusts for futureissuance. The key considerations for receivingcredit today for the promise of a positivedevelopment in the future are:

• How predictable the outcome is, and• How soon it will occur.If the analyst is reasonably assured that an

equity infusion will occur over the next two tothree years, then that event can be incorporat-ed into the financial analysis on a pro formabasis. On the other hand, analyzing an equityinfusion in the distant future, even if one couldbe certain about this eventuality, requires a dif-ferent approach. It is not meaningful to over-lay such an event on current financial mea-sures. To do so would be to isolate just onetransaction from the full picture of the compa-ny’s future, in effect, taking it out of context.Yet a program of equity issuance can be a pow-erful statement about the issuer’s financial pol-icy—an important rating consideration.

Predicting the outcomeThe first dimension of the analysis is assess-

ing the potential for issuance of, or conversionto, equity, and the likelihood of the company’sretaining that equity as permanent capital. Therisks vary by the type of instrument and its“bells and whistles.”

The following discussion is arranged in anascending order, based on the likelihood of apositive outcome. The instruments discussedconvert into common stock, although conver-sion into perpetual preferred stock is anotherpossibility that is now frequently considered.

Convertible debt usually turns into equity atthe option of the investor. The issuer can forceconversion, but only if the security is “in themoney.”

The odds of any specific issue’s converting isa function of the conversion premium and the

likelihood of the company’s stock price achiev-ing that level. Standard & Poor’s has beenextremely conservative about relying on antic-ipated stock price movements. Even when thestock is trading very near the strike price andthe firm’s future seems bright, the risk existsthat the stock will fall out of favor or that themarket as a whole may turn bearish. There aremechanisms that can increase the odds of con-version. For example, periodic adjustment ofthe conversion premium is one means.However, the difficulties in statistically assess-ing the outcomes still would limit any equitycredit given for these issues. Conversely, dis-count bonds, such as LYONs, have a built-inmechanism for always “raising the bar” as thedebt value accretes, thereby making the oddsof conversion ever more remote.

In some securities, the issuer holds theoption to convert into equity. For example,there may be a provision to pay with cash orstock. This provides a modicum of flexibility.However, there is no equity credit given. Theanalyst is still concerned that the issuer mightnot exercise its prerogative except under direcircumstances. After all, any firm can issueequity—if it chooses to—at the prevailing mar-ket price. The reality is that companies arerarely satisfied with the market price and arereluctant to add such an expensive form ofcapital. Even if the share settlement is manda-tory, a company that is disinclined to issue atthe market price would merely repurchasethose shares.

There is an analogous problem with “softcapital” from a ratings perspective. The com-pany has a contractual right to demand at anytime an equity infusion from some outsideprovider of capital. But at what point will thecompany make this demand? Moreover, in theinterim, the company does not enjoy the use ofthese funds to invest in maintaining the healthof its business.

Covenants offer another way to influencethe outcome. One popular method is to require

Equity Credit: Factoring Future Equity into Ratings

that the repayment of principal upon maturitymust be made with funds raised through theissuance of equity. From Standard & Poor’sperspective, this method of providing equity isflawed. For one thing, enforceability is dubi-ous. Second, as discussed earlier, if the compa-ny is not inclined to add equity at the marketprice, it still can meet the legal requirement ofissuing equity while simultaneously repurchas-ing its shares. (Banks have used this structureto raise Tier 1 regulatory capital. Indeed, con-sidering the regulatory impetus behind theissuance, it is unlikely that a bank would cav-alierly reverse such an equity issuance. But itwould be wrong to generalize for all corporateissuers.)

A different covenant calls for automatic con-version when a trigger event occurs—typically,a rating downgrade or a defined financial set-back. The debt would be eliminated at a timewhen the firm might find it difficult to serviceit. This represents an equity feature and helpsto place a floor under the company’s rating ifthe threshold for conversion is set high enough(e.g., at the investment-grade level).

The most favorable rating consideration isgiven to issues that are mandatorily convert-ible at a fixed time and at a fixed price.Preference equity redemption cumulative stock(PERCS) and debt exchangeable for commonstock (DECS) offer two examples. Conversionis a certainty. At the end of a very short period,the investor receives one share of commonstock—or a fractional share, if the price of thecommon has appreciated beyond a certainpoint. The company’s decision to issue theequity is based on the locked-in floor price forthe common stock. Regardless of the move-ment in the stock price, there is little reason forthe company to reconsider its decision.

Synthetic mandatory equity securities can becreated by using forward purchase contractsand related options contracts; the impactwould be equally positive from a ratings view-point. (However, if there is a substantial mis-match between the issuance of the equity andthe maturity of the debt, there is no assump-tion that the debt will be cancelled by the equi-ty proceeds. The burden of proof is on thecompany with respect to the use of the equitysums for debt reduction.)

Grantor trusts, ESOPsApart from convertibles, grantor trusts and

ESOPs offer avenues for future equity

issuance. Many companies have establishedprograms that commit them to issuing sharesperiodically as a means of dealing with large,unfunded, employee benefit liabilities. Thefirm places shares in a grantor trust or ESOPto be used over a period of time for employeebenefits that otherwise would be paid in cash.

The vehicles for these programs differ withrespect to the range of benefits that can be cov-ered, the scheduling of issuance and releases ofshares, the degree of exposure to changes inshare price, and tax treatment. The creation ofnew equity via such programs is highly pre-dictable. However, the major drawback is theextended period over which this will occur—seven to 10 years for many ESOPs and 10 to15 years in the case of “rabbi trusts,” such asFlexitrusts. This limits the positive impact oncurrent credit quality, as explained below.

Timing the issuanceAs important as knowing what will occur is

knowing its context. Events anticipated in theshort term are handled differently in the ana-lytical process than those further out.Anything expected to occur in the next two tothree years is factored into the projected finan-cial statements and credit ratios that form abasis for rating assessments. The analyst’s pro-jections cover this period, taking into accountall known aspects of an issuer’s business envi-ronment, strategy, and financial plans.Historical financials are relevant only as aguide to what may occur in the future, sinceratings address the risks of the future.Therefore, if equity is anticipated within twoto three years, the transaction can be fully ana-lyzed and incorporated in the current ratings.

The rating review of a company making alarge, debt-financed acquisition offers a com-mon example. The analysis would not focus ona snapshot view of the issuer’s financial condi-tion; rather, the rating would take into accountthe company’s plan to restore financial health,if such a plan exists. New equity is usually partof such plans. The company might issue con-vertible securities or it might commit to issuingspecific amounts of common equity over theshort term. In any event, one would expectthat the company’s timetable for accomplish-ing its objectives not exceed two or three years.

When a positive or negative development isanticipated farther out in the future, its ratingsimpact is diminished. As a dynamic entity, theissuer will be affected in many offsetting ways

n STANDARD & POOR’Sn STANDARD & POOR’Sn STANDARD & POOR’Sn STANDARD & POOR’Sn STANDARD & POOR’S




in the interim. To single out one expected eventis to take it out of context. To reflect its impactin pro forma financial ratios would be adistortion.

Still, the willingness to issue equity over timeto maintain credit quality can be an importantelement of financial policy. Establishing a pro-gram to do so represents tangible evidence thatadds credence to a stated commitment. From aratings perspective, the beneficial impact stillcan be significant, even if the equity program isnot reflected in financial ratios. Indeed, whenfocusing on the longer term, rating analysisemphasizes the firm’s fundamentals: its com-petitive position and financial policies.

In this light, consider the case of a promi-nent utility that decided to establish a “rabbitrust” to fund a very substantial amount ofemployee benefits over a 15-year period.Historically, this firm had issued a combina-tion of debt and equity to maintain its leverageat 50% and its debt rating at ‘A’. Standard &Poor’s, relying on the firm’s financial policies,was confident that the future held more of thesame. Based on the legal commitment to addmore than $1 billion of equity via the trust, thecompany lobbied for a rating upgrade.

However, Standard & Poor’s concluded thatthe future equity added little in this instance.

The company still plans to issue debt alongsidethe new equity issued by the trust. The divi-dend reinvestment plan that was used to issueequity in the past would now be discontinued.In fact, leverage at all times will continue to be50%. In short, nothing has changed. In thiscase, the equity program enhances confidencein the ‘A’ rating, rather than suggesting that therating be upgraded.

Often, companies combine share issuanceprograms with share repurchase transactions.A company may incur debt to purchase sharesalready outstanding that will be reissuedthrough a trust or an ESOP. Another option isfor the ESOP to borrow to buy shares in themarket, with the corporate sponsorguaranteeing the debt. This is known as aleveraged ESOP.

The analyst separates the dual aspects ofthese actions. The negative impact is identicalto any debt-financed share repurchase.Separately, the promise of future equity istaken into account, along the lines previouslydiscussed. The positive impact of future equityissuance usually is sufficient to partially offsetthe credit-harming effects of the share repur-chase. The net result can be an affirmation ora smaller downgrade than otherwise wouldhave occurred.


Issuers and their advisers have requested ahandy gauge of the equity credit that Standard& Poor’s attributes to specific securities, sothey can know what to expect when issuingvarious hybrids and more easily comparefinancing alternatives. The scale on the follow-ing page is an attempt to convey the measureof equity credit attributed to specific securities.

The main use of this scale should be toappreciate whether and to what extent onesecurity is better/worse than an alternativefinancing. Securities are placed on the scaleafter taking into account the overall impact ofeach security by balancing and weighing thebeneficial aspects and the drawbacks.

Equity credit of 50% means that the impactof issuing that security is half as good as theimpact of issuing common stock. The notionof partial credit can be illustrated as follows: Ifissuing a certain amount of common equitywould lead to an upgrade of two notches for agiven company, then issuing a like amount ofan instrument with 50% equity content shouldtranslate into a one-notch upgrade.Alternatively, doubling the amount of thehybrid with 50% equity content might beneeded to achieve the two-notch upgrade. (Theimpact of issuing common stock for a givencompany can be minimal or substantial,depending on the materiality of the issue andthe credit factors specific to that company’ssituation.)

Percentage equity credit has nothing to dowith ratio calculations! There is no way totranslate percentage equity credit into ratiocalculations; such calculations are determinedfor each type of instrument—and each of itsfeatures—separately. Never does the analystdivide an instrument’s amount into fractionsfor ratio purposes.

There are many hybrids that are more debt-like than equity-like. They don’t appear on the

chart, because they have a damaging—or neg-ative—impact on credit quality.

Some aspect or aspects of a debt securitymay allow it to be differentiated from “plainvanilla” debt. But that does not mean that thesecurity provides, on balance, a positive ratingimpact.

For example, bonds with very long maturi-ties are not as credit-harming as short-termdebt. In that sense, they may be said to have anequity component—but, obviously, the equitycontent is not very great! Their negativeimpact is somewhat less than conventionaldebt—but is still nearly as bad.

The scale conveys the relative impact of var-ious securities, given a typical weighting of rat-ing factors for investment-grade companies. Asmentioned above, the weighting could varywith company-specific circumstances or withthe size of issuance relative to the existing cap-ital structure. Less-than-investment-gradecompanies are excluded because the analysis ofsuch firms does not lend itself easily tostandardization. In general, the rating implica-tions for an existing rating would depend onwhether the financing replaces another that ismore/less equity-like, i.e., higher/lower on thescale.

There can be minor variations for two issuesof a single type of security. For example, thedeferral period might be six years in one trans-action and seven years in another. Obviously,the longer the deferral option, the better. But itwould be wrong to attach too much impor-tance to fine gradations. The finer the distinc-tion, the less meaningful it is in the scheme ofthings. Note, too, that the self-same securitychanges as far as equity content over its life.Remaining life is relevant, not the tenor at timeof issuance.


A Hierarchy of Hybrid Securities



Some other hybrids

• Mandatory exchangeable debt or preferred (e.g., DECs)If the issue must be settled with the stock of another entity (which is currently owned by the issuer), the analytical

treatment is that of a deferred asset sale. All asset sales may be positive or negative to credit quality; there is no stan-dardized impact. The factors that determine the credit impact include price achieved and use of after-tax proceeds. Willthe proceeds be distributed to shareholders? Or used to pay down debt on a permanent basis? Or be reinvested? If rein-vested, is the new asset more/less risky than what was sold?

• Mismatched mandatory conversion debt (e.g., FELINE PRIDES)Given the mismatch, the equity issuance is not ordinarily netted against the debt obligation. It is equivalent to a

company simultaneously issuing deferred equity (+80% in the chart above) and a like amount of debt. The net impactof these two issues would depend on whether leverage is increased or decreased, which, in turn, depends on theextent of financial leverage prior to these two issuances.

• Step-up preferredIf an instrument provides for adjustment of terms, the analyst may consider the adjustment date as the expected

maturity, with the related diminution of equity credit. If the adjustment is to above-market rates, it is presumed thatthe instrument will be refinanced—and not necessarily with another equity-like security.

• Remarketed convertible trust preferred (e.g., HIGH TIDES)On balance, this hybrid is viewed negatively, despite the potential for conversion to common and the rate

savings created by the remarketing feature. The need to remarket at a level above par could lead to termsthat are unpalatable to the issuer, prompting a refinancing.

• Auction preferredThese frequently remarketed preferreds are treated virtually as debt. They are sold as commercial paper equivalents,

which leads to failed auctions if credit quality ever falls to ‘A-3’, or even ‘A-2’, levels. While the company has no oblig-ation to repurchase the paper—the last holder could be stuck with this “perpetual” security—invariably, the issuerchooses to repurchase the preferred, bowing to market pressures to do so.



CRITERIA TOPICS

Affiliation between a stronger and a weakerentity will almost always affect the credit qual-ity of both, unless the relative size of one isinsignificant. The question is rather how closetogether the two ratings can be pulled on thebasis of affiliation.

General principlesIn general, economic incentive is the most

important factor on which to base judgmentsabout the degree of linkage that exists betweena parent and subsidiary. This matters morethan covenants, support agreements, manage-ment assertions, or legal opinions. Businessmanagers have a primary obligation to servethe interest of their shareholders, and it shouldgenerally be assumed that they will act to sat-isfy this responsibility. If this means infusingcash into a unit they have previously termed a“stand-alone” subsidiary, or finding a wayaround covenants to get cash out of a “pro-tected” subsidiary, then management can beexpected to follow these courses of action tothe extent possible. It is important to thinkahead to various stress scenarios and considerhow management would likely act under thosecircumstances. If a parent “supports” a sub-sidiary only as long as the subsidiary does notneed it, such support is meaningless.

A weak subsidiary owned by a strong parentwill usually, although not always, enjoy astronger rating than it would on a stand-alonebasis. Assuming the parent has the ability tosupport the subsidiary during a period offinancial stress, the spectrum of possibilitiesstill ranges from ratings equalization at oneextreme to very little or no help from the par-ent’s credit quality at the other. The greater thegap to be bridged, the more evidence of sup-port is necessary.

(The parent’s rating is, of course, assignedwhen the parent guarantees or assumes sub-sidiary debt. Guarantees and assumption ofdebt are different legal mechanisms that areequivalent from a rating perspective. Cross-

default and cross-acceleration provisions inbond indentures also can be important ratingconsiderations. They can provide a powerfulincentive for a stronger entity to support debtof a weaker affiliate, since they trigger defaultof the stronger unit in the event of a default bythe weaker affiliate. It should be kept in mind,however, that cross-default provisions can dis-appear if the debt whose indentures containthem is retired or renegotiated.)

A strong subsidiary owned by a weak parentgenerally is rated no higher than the parent.The key reasons for this are:

• The ability of and incentive for a weakparent to take assets from the subsidiary orburden it with liabilities during financialstress; and• The likelihood that a parent’s bankruptcywould cause the subsidiary’s bankruptcy,regardless of its stand-alone strength. Both factors argue that, in most cases, a

“strong” subsidiary is no further from bank-ruptcy than its parent, and thus cannot have ahigher rating. Experience has shown thatbankrupt industrial firms file with their sub-sidiaries more often than not.

(For rating purposes, the risk of “substantiveconsolidation” is a side issue. Consolidation inbankruptcy, sometimes referred to as “sub-stantive consolidation,” occurs when assets ofa parent and its subsidiaries are thrown togeth-er by the bankruptcy court into a single pooland their value allocated to all creditors with-out regard for any distinction between the twolegal entities. In such cases, creditors of a sub-sidiary may lose all claim to any value associ-ated with that particular subsidiary. Muchmore often, a parent and its subsidiaries willall file, but each legal entity will be kept sepa-rate in the bankruptcy proceeding. Creditorskeep their claim to the assets of the specificlegal entity to which they extended credit.Since ratings address primarily default risk, thekey issue is not consolidation, but ratherwhether a bankruptcy filing will occur.


Parent/Subsidiary Rating Links


PICS n CRITERIA TOPICS n Corporate Ratings Criteria 101


Nonconsolidation opinions are, therefore, oflittle use, since they address the likelihood ofsubstantive consolidation, rather than the like-lihood of simultaneous bankruptcies for par-ent and subsidiary. The usefulness of a non-consolidation opinion is limited to the fact thatwillingness to obtain such an opinion mightserve as some evidence of management intentregarding a subsidiary’s independence.)

Protective covenants apparently protect asubsidiary from its parent by restricting divi-dends or asset transfers. In general, this type ofcovenant is given very limited weight in a rat-ing determination. Reasons for limited value ofprotective covenants are:

• They do not affect the parent’s ability tofile the subsidiary into bankruptcy;

• It is very difficult to structure provisionsthat cannot be evaded; and

• Ultimately, courts usually cannot force acompany to obey the covenant. During severefinancial stress, especially prior to a bankruptcy,a weak parent may have a powerful incentive tostrip a stronger subsidiary. The court can, atbest, only award monetary damages after thefact to a creditor who has incurred a loss (whenthe issue defaults) and chooses to sue.

Joint ventures/nonrecourseprojects

Companies regularly invest in joint venturesthat issue debt in their own name. Similarly,firms may choose to finance various projectswith nonrecourse debt. In addition, they some-times take pains to finance some of their whol-ly owned subsidiaries on a stand-alone, nonre-course basis, especially in the case of noncoreor foreign operations.

With respect to the parent’s credit rating, thesebusinesses’ operations and their debt may betreated analytically in several different ways

depending on the perceived relationship betweenthe parent and the operating unit. These alterna-tives are illustrated by the spectrum below.

Sometimes, the relationship may be character-ized as an investment. In that case, the opera-tional results are carved out; the parent getscredit for dividends received; the parent is notburdened with the operation’s debt obligations;and the value, volatility, and liquidity of theinvestment are analyzed on a case-specific bases.The quality of the investment dictates how muchleverage at the parent company it can support.

At the other end of the spectrum, operationsmay be characterized as an integrated business.Then, the analysis would fully consolidate theoperation’s income sheet and balance sheet;and the risk profile of the operations is inte-grated with the overall business risk analysis.Or, the business may not fall neatly into eithercategory; it may lie somewhere in the middle ofthe spectrum. In such cases, the analytical tech-nique calls for partial or pro rata consolidationand usually the presumption of additionalinvestment, that is, the money the companywould likely spend to bail out the unit inwhich it has invested.

This characterization of the relationship alsogoverns the approach to rating the nonre-course debt of the subsidiary or the project.The size of the gap between the stand-alonecredit quality of the project or unit and that ofthe sponsor or parent is a function of the per-ceived relationship: the greater the integration,the greater the potential for parent or sponsorsupport. The reciprocal of burdening the par-ent with the nonrecourse debt is the attributionof support to that debt. The notion of supportextends beyond formal or legal aspects—andcan narrow, and sometimes even close, the gapbetween the rating level of the parent and thatof the issuing unit.

(If the credit quality of a subsidiary is higherthan that of the parent, the ability of the parentto control the unit typically caps the rating atthe parent level. Exceptions are made in the caseof bankruptcy-remote special purpose vehiclesfor securitization, regulated entities, indepen-dent finance subsidiaries, and the rare instancesthat have extremely tight covenant protection.The measure of control that the parent can exer-cise is very much a function of ownership, so thepercent of ownership of a joint venture or pro-ject and the nature of the other owner are criti-cal rating criteria in such situations. Where twoowners can prevent each other from harmingthe credit quality of a joint venture, the debt ofthe venture can be rated higher than either one’srating, if justified on a stand-alone basis.)

Formal support, such as a guarantee (notmerely a comfort letter), by one parent or spon-sor ensures that the debt will be rated at thelevel of the support provider. Support frommore than one party, such as a joint and severalguarantee, can lead to a rating higher than thatof either support provider.

Determining factorsNo single factor determines the analytical

view of the relationship with the business ven-ture in question. Rather, these are several factorsthat, taken together, will lead to one characteri-zation or another. These factors include:

• Strategic importance—linked lines ofbusiness or critical supplier;• Percentage ownership (current andprospective);• Management control;• Shared name;• Domicile in same country;• Common sources of capital;• Financial capacity for providing support;• Significance of amount of investment;• Investment relative to amount of debt at theventure or project;• Nature of other owners (strategic vs. finan-cial; financial capacity);• Management’s stated posture;• Track record of parent firm in similar cir-cumstances; and• The nature of potential risks.Some factors indicate an economic rationale

for a close relationship or debt support. Others,such as management control or shared name,pertain also to a moral obligation, with respectto the venture and its liabilities. Accordingly, itcan be crucial to distinguish between cases

where the risk of default is related to commer-cial or economic factors, and where it arisesfrom litigation or political factors. No parentcompany or sponsor can be expected to feel amoral obligation if its unit is expropriated!

Percentage ownership is an important indica-tion of control, but it is not viewed in the sameabsolute fashion that dictates the accountingtreatment of the relationship. Standard &Poor’s also tries to be pragmatic in its analysis.For example, awareness of a handshake agree-ment to support an ostensibly nonrecourse loanwould overshadow other indicative factors.

Clearly, there is an element of subjectivity inassessing most of these factors, as well as theoverall conclusion regarding the relationship.There is no magic formula for the combinationof these factors that would lead to one analyt-ical approach or another.

Regulated companiesNormal criteria against rating a subsidiary

higher than a parent do not necessarily apply toa regulated subsidiary. A regulated subsidiary isindeed rated higher than the parent if its stand-alone strength warrants and restrictions are suf-ficiently strong. However, the nature of regula-tion has been changing—and deregulation isspreading to new sectors. Regulators are moreconcerned with service quality than credit qual-ity. As competition enters utility markets, theproviders are no longer monopolies—and thebasis of regulation is completely different.

Still, some regulated utilities are strong cred-its on a stand-alone basis, but are often ownedby firms that finance their holding in the utili-ty with debt at the parent company (known asdouble leveraging) or that own other, weakerbusiness units. To achieve a rating differentialfrom that of the consolidated group requiresevidence, based on the specific regulatorycircumstances, that the regulators will act toprotect the utility’s credit profile. (See sidebar,page 46-47.)

The analyst makes this determination case-by-case, since regulatory jurisdictions vary.Implications of regulation are different forcompanies in Wisconsin and those in Floridaor those subject to the scrutiny of the Securitiesand Exchange Commission under the 1935Public Utilities Act. Also, regulators mightreact differently depending on whether fundsthat would be withdrawn from the utility weredestined to support an out-of-state affiliate,the parent company that needed to service its





own debt, or another in-state entity, such as acellular telephone unit. Finally, regulators maybe relied on to a greater extent to support‘BBB’ credit quality; in most cases, there is lit-tle basis to think regulators would insist that autility maintain an ‘A’ profile. Their mandate isto protect provision of services, which is notdirectly a function of the provider’s financialhealth. In fact, if a utility has little debt, theoverall cost of capital, and therefore the cost ofservice, can be higher.

There is a corollary that negatively affectsthe parent and weaker units whenever a utilitysubsidiary is rated on its stand-alone strength.If the regulated utility is indeed insulated fromthe other units in its group, its cash flow is lessavailable to support them. To the extent, then,that a utility is rated higher than the consoli-dated group’s credit quality, the parent andweaker units are correspondingly rated lowerthan the group rating level.

Foreign ownershipParent/subsidiary considerations are some-

what different when a company is owned by aforeign parent. The foreign parent is not subjectto the same bankruptcy code, so a bankruptcyof the parent would not, in and of itself, prompta bankruptcy of the subsidiary. In most jurisdic-tions, insolvency is treated differently from theway it is treated in the U.S., and various legaland regulatory constraints and incentives needto be considered. Still, in all circumstances, it isimportant to evaluate the parent’s credit quality.The foreign parent’s creditworthiness is a cru-cial factor in the subsidiary’s rating to the extentthe parent might be willing and able either toinfuse the subsidiary with cash or draw cashfrom it. A separate parent rating will beassigned (on a confidential basis) to facilitatethis analysis.

Even when subsidiaries are rated higher thanforeign parents, the gap usually does not exceedone full rating category. It is difficult to justify alarger gap, since that would entail a clear-cutdemonstration that, even under a stress sce-nario, the parent’s interest would be best served

by keeping the subsidiary financially strongrather than using it as a source of cash.

In the opposite case of weak subsidiariesand strong foreign parents, the ratings gaptends to be larger than if both were domesticentities. Sovereign boundaries impede integra-tion and make it easier for a foreign parent todistance itself in the event of problems at thesubsidiary.

“Smoke-and-mirrors” subsidiariesSome multibusiness enterprises controlled by

a single investor or family are characterized by:• Unusually complex organizational structures;• Opportunistic buying and selling of opera -tions, with little or no strategic justification;• Cash or assets moved between units to achievesome advantage for the controlling party; and• Aggressive use of financial leverage.By their nature, these types of companies

tend to be highly speculative credits, and it isinadvisable to base credit judgments on theprofile of any specific unit at any particularpoint in time.

The approach to rating a unit of such anorganization still begins with some assessmentof the entire group. Some of the affiliated unitsmay be private companies; nonetheless, at leastsome rough assessment must be developed. Ingeneral, no unit in the group is rated higherthan the consolidated group would be rated, ifsuch a rating were assigned. Neither indenturecovenants nor nonconsolidation opinions canbe relied on to support a higher rating for aparticular subsidiary.

At the same time, there is no reason for allentities in a “smoke-and-mirrors” family toreceive the identical rating. Any individual unitcan be notched down as far as needed from theconsolidated rating to reflect stand-aloneweakness. This reflects the probability that aweak unit will be allowed to fail if the control-ling party determines that no value can be sal-vaged from it. Complex structures are devel-oped in order to maximize such flexibility forthe controlling party.

Finance units are unlike other subsidiariesfrom a criteria perspective. In turn, there aretwo types of finance subsidiaries—indepen-dent and captive—that are very distinct interms of the analytical approach that Standard& Poor’s employs.

Independent finance subsidiariesIndependent finance subsidiaries can receive

ratings higher than those of the parent, due tothe high degree of separation between thesesubsidiaries and the parent. A finance compa-ny’s continuous need for capital at a competi-tive cost creates a powerful incentive to main-tain its creditworthiness. Therefore, it can beargued that the parent would be better served,in a stress scenario, by divesting the still-healthy subsidiary than by weakening it orrisking drawing it into bankruptcy. In addi-tion, there may be evidence of the parent com-pany’s willingness to leave the subsidiaryalone, including a history of reasonable divi-dend and management fee payouts to the par-ent and covenants that limit the nature and/ordegree of financial transactions between theparent and its subsidiary.

Nonetheless, a finance company subsidiaryrating still is linked to the credit quality of thecompany to which it belongs. If the financecompany’s credit fundamentals are strongerthan those of the consolidated entity, one can-not rule out the risk that this strength could besiphoned off to support weaker affiliates orservice the debt burden of the parent. In thiscase, the rating would be lower than its stand-alone assessment. Indeed, it is unlikely that anindependent finance subsidiary would ever berated more than one full rating category abovethe parent rating level. To the extent that partof the receivables portfolio were related to par-ent company sales, there would be an addi-tional tie to the parent risk profile.

Conversely, if the consolidated entity’s ratingis higher than the subsidiary’s, due to strongercreditworthiness of the other affiliates, the

analysis would attribute some of that strengthto the finance company, making possible ahigher rating than it could receive on its own.Assessing the degree of credit support usuallyincludes subjective factors, such as manage-ment intentions and shared names of the par-ent and subsidiary. In the case of a subsidiarythat has been formed or acquired only recent-ly, a demonstrable record of support is lackingand questions might remain concerning thelong-term strategy for the subsidiary. Someformal support is likely to be required. Themost frequently used support agreement com-mits the parent to maintain some minimumlevel of net worth at its subsidiary. Frequently,the parent will also agree to assume problemassets and to maintain minimum fixed-chargecoverage.

Captive finance companiesDebt of a captive finance company—that is,

a finance subsidiary with over 70% of its port-folio consisting of receivables generated bysales of the parent’s goods or services—isalways assigned the same rating as the parent.Captive finance companies and their operatingcompany parents are viewed as a single busi-ness enterprise. The finance company is a mar-keting tool of the parent, facilitating the sale ofgoods or services by providing financing to thedealer organization (wholesale financing)and/or the final customer (retail financing).

The business link between a parent and cap-tive is a key consideration supporting the sub-sidiary’s rating at the parent company level,apart from any support arrangements betweenthe two. The parent’s investment in the captive(in the form of equity and advances) may alsoprovide economic incentive to maintain thecaptive’s financial health.

Conversely, a captive that appears strong ona stand-alone basis is not rated higher than itsparent. Due to the operational tie-in, the par-ent does not have the same options for divest-ing a “healthy” captive as in the case of an


Finance Subsidiaries’ Rating Link to Parent


PICS n CRITERIA TOPICS n Corporate Ratings Criteria 105


independent finance subsidiary. Eventually,then, the captive’s bankruptcy risk is closelylinked to that of its parent. This viewpoint isbased in part on case history. A parent compa-ny bankruptcy filing will usually result in a fil-ing by its captive, either simultaneously or soonthereafter. Cross-default provisions are often thekey link. Captive finance company debtholdersmay be better off than the parent debtholders,in a liquidation or reorganization, but bank-ruptcy would impair the timeliness of payments.

MethodologyWhile the captive and parent ratings are

equalized, the two are not analyzed on a con-solidated basis. Rather, the analysis segregatesfinancing activities from manufacturing activi-ties and analyzes each separately, reflecting thedifferent type of assets they possess. No matterhow a firm accounts for its financing activityin its financial statements, the analysis createsa pro forma captive to apply finance companyanalytical techniques to the captive financeactivity and correspondingly appropriate ana-lytical techniques to the parent company.Finance assets and related debt liabilities areincluded in the pro forma finance company; allother assets and liabilities are included withthe parent company. Similarly, only finance-related revenues and expenses are included inthe finance company.

Debt and equity of parent and captive areapportioned and reapportioned so that bothentities will reflect similar credit quality. A ten-tative rating for the two companies is assumedas a starting point. Next, a leverage factor isdetermined that is appropriate for the captiveat the tentative rating level, based on the qual-ity of the captive’s wholesale and retail receiv-ables. With the appropriate leverage deter-mined, the analyst calculates the amount ofequity required to support credit quality at theassumed level, and the proper amounts of debtor equity can be transferred either to parentfrom captive or to captive from parent. Nonew debt or equity is created.

Next, the analyst determines levels of rev-enues and expenses reflective of the captive’sreceivables and debt. The levels will be in linewith appropriate profitability for the assumedrating. The higher the tentative rating, thegreater the level of imputed fixed-charge cov-erage and return on assets. For purposes of thisanalysis, any earnings support payments aretransferred back to the parent.

The analyst eliminates the parent’s invest-ment in the captive to avoid double leveraging.The captive is an integral part of the enter-prise, not an investment to be sold. While itsassets can be more highly leveraged than thoseof the parent, the methodology takes that intoaccount when determining an amount of equi-ty that is apportioned to support its debt.

Following the segregation of the financeactivity, the operating company profile maynot be consistent with the tentative rating. Themethodology is repeated, using parameters ofa higher or lower rating level. Several itera -tions may be needed to determine a rating levelthat reflects the credit quality of both operat-ing and financing aspects of the firm.

Leverage guidelinesThe receivables portfolio of the pro forma

captive is analyzed as for any finance compa-ny. Both quantitative and qualitative assess-ments are made. The leverage guidelinesmatrix (see table below) is used as a startingpoint when assessing appropriate leverageabil-ity of each type of asset being financed.Portfolios that are deemed of average qualityinclude consumer credit card, commercialworking capital, and agricultural wholesale.Auto retail paper is of higher quality, all otherthings being equal, while portfolios of com-mercial real estate and oil credit card assets aregenerally less leverageable. Adjustments aremade to reflect the performance of a given sub-portfolio. In addition, factors such as under-writing, charge-off policy, and portfolio con-centration or diversity are considered.

Securitization of financereceivables

An increasingly common funding mecha-nism for finance companies is the sale or secu-ritization of finance receivables through struc-tured transactions. Where companies sell

Debt leverage guidelines

Total debt/equity + loss reserves (%)Portfolio quality —Rating—

‘AAA’ ‘AA’ ‘A’ ‘BBB’Well above average 340 570 730 890Above average 285 505 655 805Average 255 465 605 745Below average 240 445 580 715Well below average 195 385 505 625



finance receivables, Standard & Poor’s analyt-ical approach in assessing leverage is not uni-formly to add back the sold receivables out-standing and a like amount of debt (in contrastto the case of the sale of regenerating tradereceivables of operating companies, asexplained on page 25). Rather, Standard &Poor’s focuses on the actual economic risksthat remain with the company relative to thesold receivables.

Depending on the type of transaction, theresidual risks take the form of capitalizedexcess servicing, spread accounts, deposits duefrom trusts, and retained subordinated inter-ests. If a company retains the subordinatedpiece of a securitization, or retains a level ofrecourse close to the expected level of loss,

essentially all of the economic risk remainswith the seller. There is no rating benefit that isdeserved because there is no significant trans-fer of risk—and there is no point in analyzingsuch a company differently from the way itwould be analyzed if it had kept thereceivables on its balance sheet.

Another serious concern is “moral recourse,”the reality that companies feel they must bailout a troubled securitization although there isno legal requirement for them to do so.Companies that depend on securitization as afunding source may be especially prone totaking such actions. In many situations, thisexpectation undermines the notion of securiti-zation as a risk-transfer mechanism.

PensionsDefined benefit pension plans pose risks to

their corporate sponsors since insufficientfunding, deterioration in the value of planassets, or the granting of improved benefits cangive rise to significant unfunded pension liabil-ities. (Defined contribution plans are generallynot problematic since they must be funded ona current basis and the corporate sponsor doesnot bear investment performance risk.) Theseunfunded pension liabilities are viewed byStandard & Poor’s as debt equivalents—withtwo important qualifications: there is uncer-tainty with respect to estimating the ultimatesize of the liability and the company has con-siderable discretion over what has to be paid ina given year.

Pension analysis varies by country.Government’s role in providing for pensionerscan complicate the situation. In some countriesthe flexibility for companies in distress to shiftthe burden to government—or to alter the oblig-ation itself—is greater than in other countries.Moreover, pension disclosure varies, making itextremely difficult to gauge a company’s pensionobligations accurately in many countries.

Given the difficulties with estimation of theliability—especially when interest rates fluctu-ate dramatically—the object of the exercise isnot to quantify precisely an amount to repre-sent the pension obligation. Sensitivity analysisis a better way to try to capture a firm’s expo-sure than to focus on a single figure.

The degree of discretion over payments isindeed critical. While the cash requirements forU.S. corporate sponsors are significantly shorterterm than the underlying disbursals to retirees,ERISA usually affords considerable flexibility inthe year-to-year timing of contributions. Near-term minimum funding requirements are oftensufficiently low that issuers can sharply curtailcontributions temporarily, if this is necessary tomaintain liquidity. In those instances that fund-ing is required in the near term to comply with

ERISA guidelines, the amounts involved areviewed in a different, more severe, light.

Key assumptionsThe first step in analyzing pension obliga-

tions is to examine key assumptions used toquantify pension obligations and plan assets.Standard & Poor’s scrutinizes the discount rateand wage appreciation assumptions and thegap between them. The investment perfor-mance assumption also is a key element ofexpense estimation. These three assumptionsare required to be disclosed under U.S.accounting principles. Choice of actuarialassumptions regarding mortality, dependencystatus, and turnover can also lead to more orless conservative estimations. These assump-tions are not disclosed directly in financialreporting; however, large unrecognized lossesrelating to actuarial assumptions are an indi-cation that further investigation is warranted.

Standard & Poor’s approach in assessingassumptions is to focus on differences amongcompanies. Assumptions are considered inlight of an issuer’s individual characteristics,but also are compared to those of industrypeers and general industrial norms.

Quantitative adjustments may be made tonormalize assumptions. For example, onerough rule of thumb is that for each percentagepoint increase/decrease in the discount rate,the liability decreases/increases by 10%-15%.At the very least, any liberal or conservativebias is taken into account when looking at thereported plan obligations and assets.

Financial statement adjustmentsThe next step, then, is to compare the cur-

rent value of a firm’s plan assets to the pro-jected benefit obligation (PBO)—or to the var-ious estimates of the PBO. A firm’s plan assetsas a percent of PBO is a simple, basic measureof plan solvency. Standard & Poor’s uses PBOinstead of the accumulated benefit obligation



Retiree Obligations: Pension and Medical Liabilities



(ABO) to reflect pension obligations becausePBO better captures the level of benefits thatwill ultimately be paid, assuming the firm is agoing concern and will continue to grant com-pensation increases. ABO does not includesuch a compensation growth factor.

Where companies have “flat-benefit” pen-sion plans (that is, the pension benefit is afixed dollar amount per year of service, asopposed to “pay-related” plans, where thebenefit for each retiree is derived from a for-mula tied to compensation received over aspecified period) even the PBO is likely anunderstatement of the true economic liability.This is due to the fact that for these plans, thePBO does not take account of future pensionbenefit improvements, unless such improve-ments are provided for in the current laboragreement. In such cases, the analyst seeks toestimate the additional economic liability,based on the issuer’s past pattern of grantingbenefit improvements and management’s cur-rent strategies with respect to compensation.

When PBO exceeds plan assets, the differ-ence is added back to the balance sheet as adebt-like component. Equity is revised down-ward, net of any tax considerations arisingfrom recognition of the pension liabilities.Conversely, when plan assets exceed liabilities,the difference is added back to the balancesheet as an asset, and equity is boosted like-wise. After financial statements are adjusted,financial ratios are recalculated. Of course,before incorporating these adjustments intothe financial statements, any pension-relatedliability, intangible, or prepaid asset already onthe balance sheet is reversed.

(In any event, the analyst would reverse theintangible asset created to recognize anunfunded liability when ABO exceeds planassets. This asset resulted from adoption ofFASB 87 accounting principles or from planamendments that sweeten existing benefits.FASB argues that these enhancements motivateincreased future productivity, and this futurebenefit should be recognized as an intangibleasset to be amortized over the employee’sremaining service life. In reality, though, planamendments often are only a defensive mea-sure to stay competitive with industry norms,or to prevent a labor strike. The future benefit

is at best nebulous and more likely nonexis-tent. Even if a future benefit were identifiable,it would only last until the next labor negotia-tion. Thus, amortizing over any longer dura-tion seems unjustifiable. Moreover, if unfund-ed plans actually did create intangible benefits,fully funded amended plans must foster evengreater intangible benefits! It seems inconsis-tent to recognize an intangible asset whenplans are underfunded, and not to recognize anintangible asset for fully funded plans.)

A large concern may have several pensionplans serving various constituencies. Should aspecific plan’s ABO exceed plan assets, FASBrequires recognition of a liability regardless ofhow overfunded the corporation’s other plansare. However, Standard & Poor’s adjustmentnets a firm’s overfunded plans against itsunderfunded plans when determining the pen-sion liability or asset. In theory, the corporatesponsor of an overfunded plan has the abilityto avail itself of the surplus by terminating theplan, satisfying benefit obligations through thepurchase of annuity contracts, and retainingany plan assets remaining. In practice, suchreversions are now prohibitively expensivegiven their treatment under the federal taxcode. Nonetheless, over time, reduced cashoutflows for overfunded plans will be counter-balanced by increases to future cash outflowsfor underfunded plans. For highly speculativecredits that may not have time to “shift”resources to underfunded plans, the analysiswill differ.

Beyond the determination of the plans’ cur-rent level of funding, the analyst must consid-er the likelihood of significant changes in theliability or assets in the future. The potentialfor workforce downsizing, for example, is amajor issue in the current environment. Thepotential for changes in benefits is largely afunction of the labor climate and the level ofbenefits relative to those of direct competitorsand other regional employers. Similarly, totake a prospective view of plan assets requiresthe sponsor’s input regarding its strategies,asset allocation guidelines, and concentrationlimits (including its inclination to contribute itsown equity and debt securities up to theregulatory limits).



Retiree medical liabilitiesSince 1993, U.S. companies have been

required to implement a new FASB standard:“Employers’ Accounting for Post-retirementBenefits Other than Pensions” (FAS 106). FAS106 requires companies to treat retiree med-ical, life insurance, and other nonpension ben-efits (commonly referred to as OPEBs) as aform of deferred compensation. The cost ofthese benefits is accrued over the period thatemployees render the services necessary to earnthem, instead of the prior prevalent practice ofexpensing these costs as incurred during retire-ment (i.e., the pay-as-you-go or cash method).

Under FAS 106, the actuarial present valueof all post-retirement benefits attributed toemployee service rendered to a particular dateis termed the “accumulated postretirementbenefit obligation” (APBO). The unfunded,and previously unrecognized, APBO as of thedate a company adopts FAS 106 is referred toas the “transition obligation.” Under FAS 106,companies had the choice either to take animmediate charge to income and book thetransition obligation on the balance sheet, orto delay recognition by amortizing the transi-tion obligation over a period of up to 20 years.

Most companies opted for immediate recog-nition. OPEB-related expense is higher thanunder the previous pay-as-you-go accountingtreatment, since all companies have to recognizethe current cost of benefits attributable to cur-rent service, as well as interest expense on theobligation.

Financial statement analysisStandard & Poor’s regards unfunded

OPEBs, similar to pension liabilities, as debt-like obligations. However, OPEBs are notviewed quite as negatively as straight debt,since amounts to be paid in future years areless clearcut, and are subject to change.Nonetheless, Standard & Poor’s believes that,for analytic purposes, the entire unfundedAPBO should be reflected in the balance sheetas a liability—regardless of whether a compa-ny opted for immediate or delayed recognitionunder FAS 106.

To have one basis for analysis and allowcomparisons between companies, Standard &Poor’s makes balance-sheet adjustments sothat the unfunded APBO is fully recognized.Initially, this involved restating the balancesheets of companies that opted for delayedrecognition to put them on an immediate

recognition basis. Subsequently, even compa-nies that opted for immediate recognition faceupward adjustments where the total unfundedAPBO comes to exceed the recognized liability.This occurs, for example, as a result of benefitenhancements or changes in assumptions,which FAS 106 requires to be recognized overan extended period.

Likewise, in assessing profitability, Standard& Poor’s believes it is appropriate to consideras an operating expense the accrued cost ofOPEBs earned during a particular reportingperiod, rather than the cash outlays for previ-ously earned benefits. Under FAS 106, theaccrued cost is termed the “net periodic postretirement cost.” Income statement adjust-ments are consistent with the balance sheetapproach outlined above: that is, those por-tions of the expense accrual that relate to lia-bilities amortization are eliminated from thetotal expense accrual.

Reported OPEB liability and expenseamounts are highly sensitive to differences inthe underlying assumptions. FAS 106 requiresthe same types of assumptions about employ-ee turnover, retirement age, mortality, depen-dency status, and discount rates that are usedin pension accounting. However, FAS 106also entails the use of additional and specula-tive assumptions about changes in health-carecosts, taking into account such considerationsas changes in health-care inflation, health-care utilization or delivery patterns, medicaltechnology, and the status of plan partici-pants. It is important to assess the underlyingassumptions.

In cases where a company’s retiree medicalliability burden is material, Standard &Poor’s does not rely on any single figure as adefinitive representation of the OPEB obliga-tion. Rather, sensitivity analysis may considerseveral alternative estimates and financialratios based on each.

In assessing the significance of OPEBs andother debt-like obligations to a company, theratio of total liabilities to net worth becomes amore significant ratio.

Beyond the balance sheetThere are more important aspects to the

OPEB issue than balance-sheet analysis,though. The level of cash outlays has the mostimmediate impact on a company’s financialhealth. Given the trend of increases in spend-ing for these benefits, Standard & Poor’s



focuses on prospective cash outlays.Information about a company’s workforce, themakeup of its retiree population, and its insur-ance plan characteristics helps the analyst gaina better understanding of the likely direction offuture cash outlays. The analyst will also payclose attention to management’s cost-cuttingstrategies.

Equally significant is the ability to passalong the additional expense, which is a func-tion of a firm’s competitive situation.

Most problematic are those situations wherepeers face different retiree costs. Firms thathave been relatively generous, have an olderworkforce, or a relatively large number ofretirees cannot raise prices more than competi-tors. Likewise, competitors in different coun-tries often are not saddled with similar costs,due to differences in health-care systems andbenefits in their respective countries. Any com-pany that is more burdened with such retireecosts than its competitors is penalized in theassessment of its overall cost position. Theimplications for its competitiveness are no lessthan if it had older, less efficient manufacturingfacilities. Such competitive advantage or disad-vantage is an important rating consideration.

FundingApart from limiting costs, some companies

may seek to minimize the impact of FAS 106

on financial reporting by funding their OPEBobligations. Under FAS 106, plan assets andrelated investment earnings reduce the liabilityand expense, respectively, for reporting pur-poses. The fund must be segregated, usually ina trust, like a pension fund. However, existingtax-advantaged vehicles for funding OPEBplans—including 401(h) plans and voluntaryemployees’ beneficiary associations—are limit-ed in their applicability.

Funding offsets the liability for analytic pur-poses as well—just as with pensions. However,if a company incurs debt to fund the benefits,it might be better off not funding. The compa-ny gives up flexibility in the course of replac-ing one liability with the other, since debt is amore onerous liability than unfunded bene-fits—and plan assets are not easily reverted.Moreover, efforts to rein in benefits can beundermined by the existence of funded plans.

In contrast to pension benefits, OPEBs neednot be funded as a matter of law or businesspractice. This is a critical distinction thataffects how Standard & Poor’s views the trade-off of funding vs. nonfunding and also how itviews the obligations themselves in the hierar-chy of debt and debt-like liabilities.

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