Banking & Capital Markets

In 2002, Credit Worth Not Worth Much

Record number of credit downgrades last year; blame it on utilities, telcos, and tech. Plus: Patriot Act testing the loyalty of lenders, and energy...
Alix Stuart and Stephen TaubDecember 29, 2002

Borrowing costs may have dropped to microscopic levels in 2002. But, it was still a lousy year for companies with outstanding debt.

In fact, 2002 set a record for credit-rating downgrades, breaking the previous record set in 2001, according to Moody’s Investors Service. What’s more, there were fewer credit upgrades last year than in any twelve-month period since 1991.

Specifically, 747 publicly traded companies had their credit ratings cut in 2002 — two more than the prior year’s total, according to Moody’s chief economist John Lonski. The sectors with the most downgrades? No big surprises there: wholesale electric power, telecommunications, and technology specialists. If you exclude those three groups, the number of rating reductions would have actually fallen 16 percent last year.

Moody’s lifted the ratings for a mere 129 borrowers in 2002, the fewest upgrades in more than a decade. By comparison, Moody’s upgraded the credit ratings on 219 companies in 2001 — not exactly a banner year itself for corporate creditworthiness.

What’s more, only five investment-grade companies enjoyed rating increases in the fourth quarter of 2002, the worst quarterly showing in Lonski’s records, which date back to 1986. According to Bloomberg, the previous low came during the fourth quarter of 1987, when just six companies received increases.

Interestingly, sub-investment-grade bonds enjoyed 20 ratings increases in the fourth quarter, Lonski told the wire service.

The credit picture looks a lot brighter for next year, however. For starters, a lot of companies are improving their accounting practices. In addition, few corporations have been borrowing money of late — and those that do have taken advantage of the record-low interest rates.

“You’ve had so much borrowing restraint take effect, with companies managing their debt more conservatively and benefiting from lower borrowing costs,” Lonski told the wire service. “If these forecasts for an improving economy prove to be true, chances are you are going to have fewer downgrades and more upgrades in 2003.’”

One indication that lenders are warming up to corporate credits: the risk premium for investment grade bonds (the interest rate above Treasuries) is around 1.86 percentage points. That’s down from a decade high of 2.67 percentage points on Oct. 10, according to Merrill Lynch. The average risk premium for junk bonds shrank to 8.82 percentage points from 11 percentage points.

One big reason is that investors continue to move into junk bond mutual funds. During the week ended last Wednesday, investors pumped $341 million into these portfolios, matching the prior week’s inflow, according to AMG Data Services.

In fact, junk bond mutual funds have enjoyed net inflows during 10 out the last 11 weeks, according to AMG.

It’s not coincidental that during that period, junk bond mutual funds have been staging a long-predicted rally.

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As a result, the average yield on junk bonds is around 12.09 percent – a whopping return by today’s standards.

Patriot Act Making it Tougher on Borrowers

While banks labor under the strict guidelines of the anti-money-laundering Patriot Act, the Treasury Department is still laboring to set rules for small businesses that deal with large purchases, such as used-car dealers, pawnbrokers, jewelers, travel agencies, and a host of others.

The Patriot Act, passed in October 2001 in hopes of tripping up terrorist financing (see “Patriot Games”), requires all such institutions to establish anti-money-laundering programs within six months. In April, the Treasury Department issued regulations to the traditional financial-services sector, but so far it has failed to do so for the odd coterie of remaining companies.

Why the delay? The rules for banks are absurd for certain small businesses, which typically don’t even have CFOs. “Having an individual trained in [money-laundering] compliance makes sense if you’re American Express, but not if you’re two guys with a jewelry cart at the mall,” explains Karen Shaw Petrou, managing partner at consulting firm Federal Financial Analytics Inc.

But large financial institutions aren’t complaining about the disparity. Instead, they’re in overdrive to avoid “reputational accidents” that could prove far worse than the money-laundering scandals that plagued some major banks in recent years, says Alan Abel, head of PricewaterhouseCoopers’s money-laundering compliance practice. “September 11 put money laundering and terrorist activity high in everyone’s thoughts.” That means even corporate banking customers will find themselves under tighter scrutiny.

“Customers are going to have to provide lots more information to banks and broker/dealers,” agrees Petrou. “Banks want to determine not only that their own customers and counterparties are reputable, but that their customers in turn deal only with reputable people. There is a lot of contagion risk that everyone wants to insulate themselves from.”

Thanks a Lot, Enron!

It’s the best of times and the worst of times for growth-oriented companies in troubled sectors. One dramatic example: energy trading and management company TBC Consolidated Fuels Marketing & Management Corp.

Thanks to the problems of big players like Enron, El Paso, and Dynegy, the $21 million company now has scads of new clients to chase. “There has never been a [better] opportunity to grow our market share,” says TBC ConFuels president and CEO Peter Bryant, who has seen his annual revenues increase steadily from $300,000 since entering the sector in 1997. Based on his pipeline of potential clients, he says he could easily buy 10 times the $1.5 million worth of energy he’s now purchasing monthly for Fortune 500 clients like Miller Brewing and Texas Instruments.

On the other hand, the loss of competition has also spooked the bankers, leaving TBC ConFuels without the credit financing it needs to expand business. Even armed with signed contracts from customers, bank statements, and details about the company’s hedging strategy to keep cash flow strong, TBC ConFuels was refused credit by 37 banks. Thanks to Enron, “we have found that domestic lenders are still a little gun-shy about commodity lending,” says Jacqueline Arthur, TBC ConFuels’s part-time CFO. “It’s a bit of a herd mentality.”

Indeed, “the banks are just fleeing the sector,” says Peter Rigby, an energy analyst for Standard & Poor’s. “They’re looking at an enormous number of nonperforming loans, so it’s a brave banker that brings a new loan to a credit in this sector.” Moreover, small companies are at a disadvantage, he notes, since they are more vulnerable to liquidity crunches when systemic breakdowns like energy shortages or delivery delays occur.

Patrick Von Bargen, executive director for the National Commission on Entrepreneurship, argues that it’s not Enron’s fault, and that TBC ConFuels’s problems with banks are typical for asset-light start-ups. Credit conditions “have always been bad,” he says. “When you think about entrepreneurial ventures, where the assets are often people or a brand, how does a bank foreclose on those things?”

The good news for TBC ConFuels: Bryant and Arthur discovered that international banks, including Amalgamated Bank of South Africa, French BNP Paribas, Bank of Ireland, and several smaller Canadian banks, were more willing to consider taking a chance than their U.S. counterparts. At press time, TBC ConFuels was expecting to close a deal “imminently” with one international bank, which it declined to name.

Short Take:

The average budget for an annual report jumped 13 percent, to $209,600, from 1999 to 2002, says Rivel Research Group.