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Investment Banking Credit Ratings Advisory

Brain Teasers

Credit Ratings for Blue-Chip Corporates

Companies care about their credit ratings and may have certain targets. For instance, many companies have historically aimed to maintain an investment grade rating from at least one credit agency (BBB- for Standard and Poors or Baa3 for Moody’s).

Blue-chip stocks that see widespread investor interest are broadly dividend paying, investment grade stocks. When investors look at companies such as Johnson & Johnson or Coca-Cola Enterprises, they do not want to deal with financial distress or their dividends interrupted. Management teams for these companies are cognizant of investor desires and will consider their ratings when undertaking any sort of corporate action.

Less so in the current low interest rate environment where fixed income investors have been pushing down yields due to the demand for income, but usually there is a much higher interest rate for high yield/sub-investment grade debt (BB+ or lower), which may be suboptimal for shareholders.

Although corporates who are and are looking to be rated by external credit rating agencies will be in regular conversations with S&P and Moody’s to get a gauge of where they will land. However, this is usually more of a review without any material non-public information. Should a company want to undertake a corporate action that is not yet known to the public, for instance mergers and acquisitions, they may need the opinion of an investment banker – especially under the various scenarios that they may consider in effecting a merger.

Demand for Ratings Advisory

For some corporates that have very advanced treasury divisions, such as a Royal Dutch Shell, they may have their own robust corporate models that can play around with these sensitivities. For companies that do not have strong modeling capacities, they will lean heavily on the investment banker. Companies that are sub-investment grade and looking to become investment grade may also be curious about what levers to pull to get across the line.

Investment bankers will take the documents provided by the client and create a flexible operating or financial model that will show indicative overall ratings as well as the pain points that agencies have identified as ratings downgrade thresholds. For example, should Funds from Operations to Debt fall below 45%, Moody’s may consider a downgrade.

As ratings agencies normalize financials to suit their standards, companies rely on investment bankers to know how to adjust operating leases to convert them into the appropriate capital leases and figure out the nuances of pension interest. Bankers should also know how agencies respond to return of capital initiatives such as a large dividend raise or share repurchase financed by debt.

Getting a precise output for Moody’s or S&P ratings requires extensive accounting and financial modeling knowledge, and this ends up being a lucrative division for the investment banks, either directly through fees or as a “free” service that elicits other business.

Preferred Shares and Hybrid Debt for Ratings Relief

Corporates that have are tapped out from debt markets but require more capital for whatever corporate purposes usually prefer not to issue equity as it dilutes existing shareholders. When issuers are sufficiently creditworthy, preferred shares or other equity-like instruments may be an alternative as they receive favorable treatment from the rating agencies – who consider them to be equity to some extent when conducting their calculations.

Preferred shares are a common instrument after debt and equity. They benefit from having partial or full equity treatment from credit agencies until certain thresholds while their dividends do not count against interest coverage metrics and the capital improves debt/equity or debt/capitalization calculations. However, the preferred dividends are not tax deductible and overall represent a reduction of cashflow to common shareholders.

Other instruments include hybrid debt, which is more esoteric than preferred shares but not uncommon. Hybrid debt is characterized by very long dated (60 years) debt that is subordinate (not pari passu) with the other debt in the capital structure, such as the bonds or bank loans. They receive partial equity treatment from a rating agency standpoint but also enjoy tax deductibility on their “interest”. Hybrid debt is usually rated at two notches below the unsecured debt of the corporate. The catch is that interest payments are usually higher for the risk of holding hybrid debt.

Debt Capital MarketsBullet Debt · Working in Treasury · Debt Capital Markets Analyst and Associate Work · Credit Rating Agency Analyst · IB Credit Ratings Advisory · Early Bond Redemption Analysis · Hedging Interest Rate Risk ·
Investment BankingShould You Start Your IB Job Early? · IB Teaser · Why IB? · Breaking into IB as a Big 4 Accountant in Audit · IB Credit Ratings Advisory · WACC and Optimal Capital Structure Reviews · IB in Canada ·
ex investment banking associate

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