Ratings: When corporates can trump sovereigns
Several factors can place corporate credit ratings higher than that of the domicile country
- Local and foreign currency rating distinctions are important
- Country ceilings are often seen as a constraint on foreign currency ratings for corporates and structured notes
- There are several reasons why a corporate can have a better rating than its sovereign
- Sovereign downgrades are, at least in part, questions of judgement
Greece’s ‘country ceiling’ was revised down from AAA to B- in May 2012 by Fitch. Italy’s sovereign rating is currently BBB but on a negative outlook. What do such changes mean for the ratings of corporates in those countries? Can corporates have higher credit ratings than that of the country they are domiciled in and what, if any, is the relationship between the two?
Corporates in the euro-zone in particular face unique considerations in the links between corporate and sovereign ratings. Moody’s country ceiling methodology, for example, explicitly notes the expectation that ceilings will be higher for euro-zone countries, typically at six notches above the government bond rating, than it would be if those countries were not part of the union.
A local currency credit rating gives a ranking for default likelihood for entities relative to all others in a universe of local currency ratings, says Alex Griffiths, an analyst at Fitch. Foreign currency ratings come into play, particularly with emerging markets, where there is an additional risk of sovereigns impeding the transfer of funds to meet debt obligations.
For Moody’s, a local currency country risk ceiling is an absolute constraint on all domestic ratings but usually set higher than the sovereign bond rating, says William Coley, a group credit officer. It indicates the highest rating in local currency that might be assigned to the financially strongest credit domiciled or originated in a country. It applies to local issuers and structured notes whose cashflows are largely exposed to the local environment. The sovereign is usually the strongest credit in its country and for Moody’s, 97% of all corporate ratings are at or below the sovereign. Of 2,500 corporate bond ratings, about 65 are rated higher than the sovereign, of which 50 are only one notch higher.
Fitch sees country ceilings as a constraint on foreign currency ratings for corporates and structured notes as they capture the risk of capital and/or exchange controls (known as transfer and convertability or T&C risk) preventing the ability to convert local currency and transfer proceeds abroad, says Griffiths. The ceilings can generally be up to three notches above the sovereign foreign currency rating.
The euro-zone common currency reduces T&C risk, allowing wider notching between the country ceiling (up to six notches higher) and the sovereign rating. This means that, in practice, the T&C risk implied by country ceilings rarely caps foreign currency ratings, given the ECB’s control of the currency. However, low sovereign ratings in Italy, Portugal, Greece and Cyprus do drag down corporate ratings.
Despite this, there are several domestically focused corporates with ratings higher than their sovereigns. This is particularly true in Italy with companies such as Acea, CVAS, Enel, Eni, Italgas, Snam and Terna. The same is true of Red Electrica in Spain.
Turkey is another example of a country whose corporates have higher ratings than the sovereign. Several Turkish companies are rated one notch above the government’s Ba3 bond ratings, says Coley. They achieve this because of their market-leader positions; material offshore revenues or revenues linked to hard currency; active currency risk management policies; strong balance sheets and healthy liquidity.
What determines whether a corporate can be rated above its sovereign? Fitch looks at several factors beyond geographical diversification of the underlying business. These include the underlying financial performance; issuer-level liquidity, including an assessment of the syndicate of banks providing back-up liquidity; other measures of market access, including sharp volatility in equity or credit default swap pricing; and any institutional disruption within that jurisdiction short of capital controls (such as taxation and directed deposits). The utilities sector, particularly in Italy, has a several examples. They are generally a result of independent and transparent regulation, which currently protects these companies from volume and price risk, providing operating cash flow visibility and offsetting the typically negative free cash flows.
What happens with a sovereign downgrade then becomes a question of judgement informed by factors such as assessments of demand, funding, the timing and extent of regulatory and fiscal intervention by the government on the companies’ results. Historically, this has resulted in Fitch corporate ratings that are higher than the sovereign by typically up to two notches for domestic corporates. As a result, given the negative outlook on the Italian sovereign, investors should not panic when it comes to Italian corporates.