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Figure 3.1 presents a currency-issuer-rating triangle. There are important credit linkages among the three profiles shown. Clearly, a company must be based somewhere. Hence, a company’s issuer rating is going to be influenced by the currency in which it transacts its daily business, and the local
PRODUCTS, CASH FLOWS, AND CREDIT
currency rating is thus a relevant consideration. However, this is not to say that the local currency rating serves as a ceiling for what any issuer rating might aspire to; a local government would have limited interest in restricting free access to its own currency. Yet the foreign currency rating, which evaluates the local government’s stance on unfettered access to foreign currencies, can serve as ceiling to a local issuer’s rating. However, there are several ways that an issuer’s financial instruments might secure a rating above the relevant foreign currency rating. In almost every case where an issuer’s rating rises above the local currency rating, the crucial factor is the issuer’s being able to have access to some nonnational currency(s) in the event of a country-level default scenario.
While these various risk considerations are not of any immediate concern for G-7 and other well-developed markets, they can be quite important for emerging market (nondeveloped markets like those of certain parts of South America or Africa) securities, a segment of the global market that is large and growing.
For more of a discussion on the important role of currency ratings and their impact, see “Emerging Markets Instability: Do Sovereign Ratings Affect Country Risk and Stock Returns?”, February 2001, by Graciela Kaminsky of George Washington University and Sergio Smukler of the World Bank. They find that the answer to the question posed in their title is “yes.” As to specific case studies, consider the instance of Standard and Poor’s decision in September 2002 to lower India’s long-term soverign currency rating from BBB— to BB+ and to downgrade India’s short-term local currency rating to B from a previous A-3. Consistent with previous adverse announcements by Standard and Poor’s about India (dating back to at least October 2000), currency, equity, and bond markets reacted negatively to the news. A headline from the ENS Economic Bureau as provided by Indian Express Newspapers on October 11, 2000, read “S&P Downgrade Hits Rupee [currency], Bonds.”
Earlier it was stated that rating agencies can assign credit ratings to companies as well as to the financial products of companies. When a credit rating is assigned at the company level, unless something dramatic happens in a positive or negative way, the rating typically sticks for a rather long time (sometimes many years). A company can do very little on a day-to-day basis to greatly influence its overall credit standing. Conversely, a company’s financial products can be structured on a very short-term basis so as to satisfy rating agency criteria for receiving a rating that is higher than the overall company rating. In some instances a company may even seek to issue products with a rating below the company rating.
Generally speaking, all of the ways that a company might influence its financial product ratings are ultimately linked to cash flow considerations. This section presents those cash flow considerations in two categories as they relate to spot and bonds: collateralization and capital.
COLLATERALIZATION AND CAPITAL
Collateralization is one of the most basic and fundamental considerations when evaluating the credit risk of a bond (or any security). When a bank considers a loan to a homeowner or businessperson, one of the first things it is interested in learning is what the potential debtor has of value to collateralize against the loan. When it is a home loan, the home itself generally serves as the collateral. That is, if the homeowner is unable to make payments and ultimately defaults on the loan, then the bank often takes possession of the home and sells it. The proceeds from the sale go first to the bank to cover its costs and then any remaining funds will go to the homeowner. At the time a loan application is being reviewed, the bank also will want to review a homeowner’s other assets (investments, retirement funds, etc.) as well as annual compensation.
PRODUCTS, CASH FLOWS, AND CREDIT
With a business loan, the businessperson may have little capital in the business itself. The person may be renting the office space, and there may be little in the way of company assets aside from some office furniture and computer equipment. In such a case, the bank may ask the businessperson to provide some kind of nonbusiness collateralization, such as the deed to a property (a home or perhaps some land that is owned). If the business is profitable and simply in need of a short-term capital injection, the documented revenue streams may be sufficient to assure the bank of a business’s creditworthiness. However, even if the business loan is granted and primarily on the basis of anticipated revenue, it is very likely that the rate of interest that is charged will be higher than what it could have been if collateral had been provided.