Resilience of corporate ratings amidst the Eurozone crisis
Discussing why corporate debt ratings have weathered sovereign downgrades
By Richard Hunter, Fitch Ratings | CFO UK | Published 18:12, 16 January 13
At Fitch, lower sovereign ratings for countries in the Eurozone periphery have generally had little direct impact on our corporate sector credit rating levels.
Whilst the fragile economic environment has undoubtedly pressured company’s fundamentals, the scale of negative rating movements seen for corporates has generally been consistent with a normal recessionary period, rather than driven by any material linkage to their sovereign. A key reason for this is that when assessing corporate credit default risk the Eurozone – as a single currency bloc – retains key advantages.
Firstly, transfer and convertibility risk – the risk that a company will not have enough foreign exchange available to meet its foreign currency debts – is materially lower compared to the effect of sovereign downgrades typically seen in non-Eurozone countries. Secondly, the euro is also a global reserve currency and the union‘s membership still has a high average member sovereign rating.
As a result, under Fitch’s corporate rating methodology, Eurozone corporates can be rated up to six-notches higher than their respective sovereign’s rating. That represents a significant gulf and as a result to date most corporates remain comfortably below these levels.
However, despite this strong level of corporate insulation to the Eurozone sovereign crisis, the limit of six rating notches does still reflect the tail risk to companies from a hypothetical sovereign default provoking or coinciding with a sovereign’s exit from the currency union.
As an example of how far sovereign ratings would have to move to directly affect corporates, Spain – rated ‘BBB’ with a negative rating outlook by Fitch - would have to be downgraded by another full rating category into sub-investment grade territory (‘BB+’ and below) before the country‘s last remaining ‘A’ category rated corporate (Enagas, rated ‘A−‘ with a negative outlook) would be directly affected by rating linkage to the Spanish sovereign.
In Portugal, given its lower sovereign credit rating - rated ‘BB+’ with a negative rating outlook by Fitch - the linkages between the sovereign and corporate sector are that much closer. But even here a further two-notch sovereign downgrade to the edge of the ‘B‘ category would be needed to affect local companies’ credit ratings such as Portugal Telecom (rated ‘BBB’ with a negative outlook) and Energias de Portugal (EDP) (rated ‘BBB-‘ with negative outlook). As a result, given our November 2012 affirmation of Portugal’s sovereign ratings, corporate ratings look appropriate at these levels.
However, despite this broad level of rating insulation for corporates in the Eurozone periphery, one sector has already seen an above-average rating impact this year as an indirect result of the sovereign crisis. This has been the utilities sector, where sovereign stress on Portugal and Spain has resulted in a more unpredictable regulatory framework.
Utility company credit ratings typically permit higher financial leverage for a given rating category as recognition of the greater level of predictability of cash flows. Therefore, it has been the erosion of this predictability through more hostile regulation, rather than a risk of sovereign defaults, which has driven negative rating actions for these companies.
As an example, Fitch placed all Spanish utility companies and any other utilities with a sizeable revenue exposure to Spain on a rating watch negative in April. This was in response to the government’s budget measures, such as a 12 percent reduction in electricity distribution revenues, as well as uncertainty over future additional measures that it may put in place for regulated utilities.
In August, we then downgraded the ratings of Spanish integrated utilities such as Iberdrola and Endesa by one notch due to persistent weak fundamentals, a more hostile and uncertain regulatory framework and signs of political intervention, as well as the continued stressed financial environment.
These companies all remain on a negative rating outlook but, as discussed previously, they also benefit from a more sizeable rating linkage gap to their sovereign (of a whole rating category) before their ratings would be directly impacted by any further potential move in the Spanish sovereign rating.
Portugal is again another good example here. In August, we downgraded EDP two rating notches to the lowest rung of investment grade due to the company’s slower pace of deleveraging and the declining predictability of the regulatory environment – the latter provoking a harsher outcome than for its compatriot Portugal Telecom.
At this level, its ratings are now effectively unconstrained by the ratings of Portugal, and the latter would only provide a negative trigger in the event of a further multi-notch sovereign downgrade of two notches or more.
Richard Hunter is the head of EMEA and APAC region corporates at Fitch Ratings.
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