The Economy

Corporate, Sovereign Debt Ratings Closely Linked: S&P

Armed with new methodologies and assumptions, the credit rating agency is taking a harder look at whether corporate issuers can earn higher ratings...
Vincent RyanApril 29, 2013

If a company is a better credit risk than its home country, it might still have trouble getting a credit rating agency to recognize that fact.

Under new methodologies proposed by Standard & Poor’s this month, some companies could find it slightly harder to  “pierce the country ceiling”— earn a better credit rating than the countries they operate in.

Before the financial crisis, the impression was that credit rating agencies had stopped rigorously applying the “sovereign ceiling” policy. But Standard & Poor’s published a request for comment on April 12 revealing how it plans to assess whether a corporate issuer deserves a credit rating above its home country or above any other nation in which it does substantial business. 

S&P emphasizes in its proposal that it “long ago rejected the notion of constraining all ratings at the level of the sovereign rating” and that overall it is not changing its view on the matter. Indeed, excluding public finance debt and securitizations, more than 100 issuers globally have S&P ratings above the sovereign.

With the proposal, S&P is putting out more specifics on the hypothetical sovereign default scenarios it will use to stress test corporate ratings and placing a cap on the number of notches above the sovereign that a corporate can be rated, says Laura Feinland Katz, managing director and chief criteria officer for emerging markets at S&P.

S&P’s proposals were informed in particular by happenings in Europe and “the significant sovereign rating transitions in Western economies in the last year,” says Feinland Katz. S&P says the sensitivity of certain business sectors to country risk is higher than S&P previously thought. Pointing to the situation in Cyprus, where there was a freeze on deposits and capital controls, S&P says there is now a greater degree of “tail risk” when a country is experiencing severe economic stress.

But S&P also drew from history to establish the connection between sovereign crises and corporate defaults. Some of the foundation for the stress tests it proposes for example, are based on large declines in gross domestic product in Mexico in 1994; Thailand in 1997; and Russia in 1998.

In the case of emerging markets, for example, defaults by speculative-graded corporates reached 16 percent in Brazil in 2002 during the Argentinean debt crisis. In 1998, the Russian and Asian macroeconomic crises led to speculative debt defaults of 8 percent.

Meanwhile, in developed markets like Spain, a drop in the sovereign’s rating and a weakening of the banking system has led to a “more hostile” environment for corporate issuers, Feinland Katz says.

When S&P does rate a company above a sovereign foreign currency rating – the rating the agency places on sovereign debt raised in foreign currencies – it’s saying that “the entity’s debt-servicing ability is superior to that of the sovereign, and that, ultimately, if a sovereign foreign currency default occurs, there is no appreciable likelihood that the issuer or issue will default.”

S&P’s criteria combine a stress-test scenario related to a hypothetical sovereign debt crisis; a limit on how much a company’s rating can exceed the sovereign’s; and an assessment of a company’s exposure to potential capital and currency controls that sovereigns sometimes impose in a crisis.

In many situations, the stress test would be applied to not just a company’s home country but also other nations in which it has “material exposure … and whose sovereign foreign currency rating is lower than the proposed credit rating on the [company].”

S&P will use three kinds of sovereign default scenarios for stress testing, although the elements of each of the scenarios are subject to change, depending on market feedback: a case of economic stress that is not accompanied by currency devaluation; economic stress with currency devaluation; and a case where there is significant risk of a country exiting a monetary union.

The effects of these stress scenarios on corporates, according to S&P, would be numerous and severe, and include lower revenue and earnings, a sharp increase in costs for short-term and floating-rate debt and a lack of capital market access.

But a stress test will not be required if the sovereign has a sovereign foreign currency rating of AA- or higher, S&P says. In that case, S&P would use some qualitative measures to examine if a company would default in the unlikely event the sovereign did. “We would still need to make the case why the [issuer] would be resilient,” Feinland Katz says.

For example, says S&P, an issuer would maintain its credit rating if it had “few links to the sovereign through contracts, revenues, subsidies or guarantees … from the government.”

Even if in the United States a company’s rating is safe, S&P would apply the criteria in relation to other sovereign debt when the company has significant exposure there — either through overseas operations, foreign currency dealings or export markets.

And even if a company passes the stress test, the S&P criteria would allow only a four-notch ratings differential between the sovereign foreign currency rating and the higher corporate rating. This is to anticipate low-probability, high-severity events – like a  deposit freeze, currency redenomination, or geopolitical event ­– that are not captured in the stress tests, S&P says.

The maximum differential could also be lower depending on the company’s relative sensitivity to sovereign-related risks: for example, S&P considers life insurers, banks, regulated utility infrastructure companies and non-exporting cyclical companies – like producers of steel, chemicals and autos – highly sensitive to sovereign-related risks.

Finally, a corporate rating from S&P can be capped by the agency’s estimate of “transfer and convertibility (T&C) risk” in certain sovereigns. A.M. Best defines T&C as “the risk that capital and exchange controls may be imposed by government authorities that would prevent or materially impede the private sector’s ability to convert local currency into foreign currency, transfer funds to nonresident creditors or both.”

If a company is heavily exposed to a single jurisdiction, S&P says its rating would be capped by S&P’s assessment of T&C risk unless the company has political risk insurance or third-party guarantee.

S&P says the new criteria, if currently applied, would affect less than 1 percent of corporate and government issuers and by no more than two rating notches. Besides the stress scenarios, S&P is seeking market feedback on the maximum ratings differential and its judgment of which industries are most sensitive to sovereign-related stress. The deadline for responses is May 13.