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Bond-rating game is more about performance than odds

“It is extremely important. In the financial world, there are few things more sacred than a bond rating. There are only 10 companies in the world that qualify for Aaa from Moody’s (Investors Service Inc.),” says Stephanie Webster, senior financial consultant for Pittsford Capital Group Inc. The other leading rating service, Standard & Poor’s Corp., currently lists 12 companies at the AAA level.
Walter Woerheide, a professor of accounting and finance at Rochester Institute of Technology, notes that as a bond promises fixed interest and a payback at maturity, a bond rating “is an independent assessment of the likelihood of default on the bond.”
Experts explain that higher bond ratings mean two things: A bond issuer (corporation, municipality, utility) can pay a lower interest rate. And investors can expect a more secure investment.
“If you are a GE (General Electric Co.), when you put out a bond, you do not have to pay quite as high an interest rate,” Webster says. “The more secure you are, (the more) you do not have to pay a high interest rate.”
If a typical company pays 7 percent interest, a top-rated company will pay 6.5 percent.
Michael Dorfsan, director of communications for Standard & Poor’s in New York City, says the ratings provide information for both the company and potential investors.
“We try to apply a rating that is the right, appropriate rating so that the issuing company has access to debt capital,” he says, “at the same time providing information to investors so they know what kinds of risk that will entail.
“The bond rating acts as a way to bring the issuing bond rating and investing together.”
Charles LaRocco Jr., a Brighton-based senior investment executive for Key Investments, a subsidiary of KeyCorp, explains that for investors the bond ratings define how much risk is associated with the bond. Very conservative investors, for example, will want a bond rated at A or better, he says.
“You look at how it is rated vs. how it is paying,” he says. A lower-rated bond pays a higher interest rate, but involves more risk.
Experts say that while the bond ratings are not as mysterious as they might first appear, they do include subjective information. Rating analysts look at numerical information, such as debt ratios. But they also consider data subject to interpretation such as strength of management and market environment.
Dorfsan says Standard & Poor’s publishes a 90-page booklet that outlines the financial ratios and other information its analysts look for from each business sector.
“By publishing our criteria we really provide a great deal of information,” he says. Each area–for example, international corporations or utilities–have different criteria for rating evaluation.
“We take into account the differences in each industry,” he says. The standards remain fairly constant, but do reflect new developments in each market.
Dorfsan says Standard & Poor’s assigns a committee of analysts to study each company. The analysts possess expertise in the issuing company’s business area, such as forest products, cable TV and so on. The team of experts does research and then meets with company officials. Before the meeting, the analysts review pertinent information, including five years of published financial statements, cash-flow projections, transaction documents and supporting legal opinions.
“We aim at obtaining all the material we need, but it is a collaboration (with the company officials). We are trying to be fair,” Dorfsan says. The evaluation stage varies depending on the complexity, but takes at least several weeks.
After completing the research and meeting with the company, a rating committee meets. The committee, consisting of five to eight analysts, discusses where to set the rating and then votes on it.
“Each analyst will vote. People are encouraged to speak up. They can agree or disagree,” Dorfsan says.
After the committee decides on a rating, it notifies the company. “Most of the time they (the company officials) agree with the ratings. There has been discussion along the way,” he says. “(But) they do have an opportunity to appeal and provide the committee with additional information.”
The company then releases the information to the media, and publishes it.
Woerheide says the ratings services focus on a handful of items. First, the analysts consider the debt ratio of the issuing company. They assess how much debt the company has currently and will have after the bond issue.
They also look at the ratio of operating income (earnings before interest and taxes) to interest expenses for the company from all sources of debt.
“The higher the ratio, the better the rating. The more times over the company could make the interest payments, the greater the safety margin,” he says.
The ratings analysts also examine the contract–called an indenture–attached to each bond. It spells out the details, including the collateral and the amount of protection to bond holders.
The final two areas that the services look at fall into the subjective category, Woerheide says. “They look at the management of the firm: how well it is managed, the strength of the management team, future plans.” They also scrutinize the industry and markets where the business competes.
“It is much more likely that companies growing in a good market will get a higher rating,” says Woerheide. “They (the analysts) put it all together and give a probability of default.”
When a company pays for a rating, the price includes “surveillance” or tracking. That means following the company and adjusting its rating.
Dorfsan says that investors trade the bonds and need to know their value.
The same analysts that set the initial rating follow the companies. They review company filings and annual reports.
The ratings can go up or down. In the second quarter of 1996, for example, Standard & Poor’s changed the following ratings: industrial companies had 34 upgrades and 27 downgrades; telecommunications, two upgrades and one downgrade; and utilities, five upgrades and three downgrades.
“The ability to sell bonds is based on the market’s confidence in the company’s ability to pay the interest,” he says. “We do not say whether to buy or sell–we remain objective.”
Experts say that the only way to secure a better bond rating is to improve the health of a company.
Says Woerheide: “The ratings are basically good. Ratings are unbiased and a good measure of the probability of default.”
For a company to improve its rating, officials must make it a stronger company, he says. The improvement can occur in the statistical areas by decreasing the debt ratio or improving the operating-income-to-interest ratio. The company could also bring out a new product that promises growth potential.
“There is no quick little fix,” Woerheide says.
LaRocco says companies must plan ahead to ensure a solid rating.
“It is nothing they can do overnight. They need to look down the road and get their budgets in order,” he says. “It is just based on the ability to pay their debt.”
The first efforts at improving a company’s rating should occur within the firm’s internal-audit system, he says. That audit should raise red flags on items that could damage the rating.
Some companies use third-party managers or consultants to help them improve.
“By the time it gets to bond underwriting, they have to have gotten their ducks in order,” LaRocco says.
Several years ago, criticism stung the ratings services after some highly rated bonds failed. Now, some officials say the services are too conservative in the ratings.
LaRocco says he hears complaints about too-conservative ratings.
“I tend to agree with that. It is almost like they overcompensated for the criticism,” he says. “It’s a two-way sword; it (lower ratings) forces companies to give a higher rate to investors, but it is inflationary. They pass it through somewhere. It’s a vicious cycle.”
LaRocco says the ratings companies also seem to mirror how each upgrades or downgrades ratings.
Dorfsan says that Standard & Poor’s tries to be fair to the investor and the bond issuer.
“We always hear comments that the rating companies are too quick to downgrade and not fast enough to upgrade,” he says. “The thing company officials should understand is that the bond rating is only one aspect. What the company has to contend with is managing a business.”
Dorfsan cites an example where a company purchases a competitor. The increase in debt could cause the bond rating to plummet.
“It might still be a good strategic decision for the company,” he says. “The bond rating is not the only objective.”
Dorfsan adds that the large insurance companies and banks all have their own credit departments, yet they still maintain confidence in the ratings.
“If we rated issues too high, the investors would be wary and have less confidence in the rating,” he says. “If it is rated too low, it is not fair to the issuer. We are judged every day by the market.”
Webster says that debt ratings remain important and, in her view, consistent.
“Fortunately the ratings companies have kept the criteria constant. It is a good yardstick for the health of a company.”
(Mike Dickinson is a Rochester-area free-lance writer.)

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