Leveraged Finance: Standard & Poor s Revises Its Approach To Rating Speculative-Grade Credits

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1 May 13, 2008 Leveraged Finance: Standard & Poor s Revises Its Approach To Rating Speculative-Grade Credits U.S. Contacts: Nicholas D Riccio, Managing Director, New York (1) ; nick_riccio@standardandpoors.com Solomon B Samson, Managing Director, New York (1) ; sol_samson@standardandpoors.com European Contact: Vincent Allilaire, Director, London (44) ; vincent_allilaire@standardandpoors.com Asia-Pacific Contact: Terry Chan, Senior Director, Melbourne (61) ; terry_chan@standardandpoors.com Latin America Contact: Eduardo Uribe, Managing Director, Mexico City (52) ; eduardo_uribe@standardandpoors.com Table Of Contents Ratings Have Moved Down The Credit Spectrum Speculative-Grade Rating Refinements Meeting The Demands Of A Changing Market 1 Standard & Poor's. All rights reserved. No reprint or dissemination without S&P's permission. See Terms of Use/Disclaimer on the last page

2 Leveraged Finance: Standard & Poor s Revises Its Approach To Rating Speculative-Grade Credits Standard & Poor's Ratings Services recently reviewed its approach to rating leveraged credits. This process included independent market research and a very hard look at key analytical issues within the leveraged markets. The review has prompted us to introduce several enhancements to our analytical approach. While issuer credit ratings continue to provide an intermediate indication of default risk, we have revised the emphasis of our analysis for speculative-grade ratings to look out over a two-year time horizon. In determining our speculative-grade rating outlooks, we will similarly place emphasis on a one-year time horizon. In addition, we will use a more sophisticated weighting of rating factors for this level of credit quality. Our plan is to also bolster transparency by including in our published reports a more detailed discussion of alternative scenarios that could cause a transition in a rating or outlook, as well as a higher level of specificity when discussing covenant compliance and headroom. Ratings Have Moved Down The Credit Spectrum For almost three decades, the leveraged finance business has continued to grow. In 1980, about 32% of U.S. industrials ratings were below investment grade; today, that number has swelled to 72%. Moreover, while a significant portion of speculative-grade ratings were in the 'BB' category (i.e., 'BB+', 'BB, or 'BB-') in the early 1980s, below-investment-grade ratings were dominated by the 'B' category in 2007 (see chart 1). Chart 1 Standard & Poor s RatingsDirect May 13,

3 Currently, at about 46%, the 'B' category dwarfs all other rating categories. Chart 2 illustrates the number of new 'B' rated issuers by year. Chart 2 Also, because of recent substantial issuance by even lower-rated credits, our most populous rating designation has slipped to flat 'B' from 'B+' (see table). U.S. Industrials 'B' Category Distribution B+ 57.5% 37.9% B 29.3% 46.3% B- 13.2% 15.8% A variety of factors have fueled this growth in the lower end of the credit spectrum, including the higher risk tolerance of investors, cheap money, and greater access to capital by speculative-grade issuers. Over the years, as ratings have migrated, Standard & Poor's has revised its approach to add more value at the lower end of the credit spectrum. This has included the introduction of rating outlooks, greater focus on cash flow analysis, greater emphasis on liquidity analysis, enhanced surveillance efforts, and the assignment of recovery ratings (which estimate recovery prospects in the event of a payment default). The market's increasing willingness to accept riskier credits in recent years prompted a review of the methodologies used in arriving at our opinions regarding creditworthiness. 3

4 Lower ratings spur the need for more timely information and greater transparency The migration down the credit spectrum has translated into greater ratings volatility, and a related need for more timely information. Lower rated entities are more sensitive to changes in business and financial conditions, and more subject to change. Investors have shown even greater interest in "credit transitions," or changes, since there is less room for error at the lower end of the credit spectrum. The market has come to appreciate more information about the likelihood of a rating change, the conditions that may lead to a change, and our view of the time horizon for such potential credit improvement or deterioration. We intend to enhance the timely delivery of truly transparent opinions and forward-looking rating information. Credit ratings that reflect long economic cycles, or seek to look through the influence of business cycles themselves, are not representative of the performance of non-investment-grade credits; ratings that reflect near-term challenges are more germane. Having a nearer-term focus with respect to a company's risks and opportunities, as well as making subtle distinctions, is important in the speculative-grade area, especially given the substantial concentration of ratings within the 'B' category. Different approach for speculative grade than for investment grade For investment-grade companies, risks and opportunities are typically placed in a context that can span several years. Understanding the challenges and opportunities that these companies may face over time is an important factor in our rating decisions. The market expects a greater level of stability from investment-grade ratings (see chart 3), and tends to take a longer term view of the prospects of an issuer. As a result, the degree of volatility in the ratings tends to be more moderate than the amplitude of a company's cyclical high or low. A time horizon in the three- to five-year range, which generally allows us to rate through an economic down-cycle, is not unusual for these ratings. Standard & Poor s RatingsDirect May 13,

5 Chart 3 While market participants seem to believe that we always try to rate through an economic cycle, this ideal does not readily apply to the lower end of the credit spectrum. Trying to rate a 'B' credit through an economic cycle could translate into a very conservative approach to the credit analysis and would fail to recognize that cyclical influences are among the key causes of default. This would, in effect, produce ratings with limited value. For speculative-grade companies, change is the rule--and making adjustments to the ratings when appropriate is the key to adding value. By their very nature, speculative-grade credits offer less visibility and require a more dynamic approach to weighting their risks. (Our market research has confirmed that investors take a more near-term approach when it comes to leveraged investments.) Thus, placing analytical emphasis on a shorter time horizon for speculative-grade ratings is more appropriate. For example, massive debt maturities that a company may have to deal with in the next 12 to 18 months are much more relevant than business risk concerns that a company may have to deal with four or five years from now. The refinancing requirement creates a near-term risk with a relatively high level of occurrence--especially for a speculative-grade company--and deserves to be greatly weighted. Conversely, for that same company, the prospect of a potential business challenge five years hence should carry less weight in arriving at a rating opinion. Liquidity considerations play an increasingly important role Indeed, in leveraged finance, liquidity considerations have played an increasingly large analytical role. Investors have reacted positively to our efforts in this area, but they've also indicated that we should do still more with respect to 5

6 structure and covenants, especially covenant headroom and triggers. Investors have become wary of "covenant-lite" loan agreements, and covenant analysis now plays an important role in our overall credit analysis. For instance, a company may have a very large bank facility that it intends to use to meet near-term debt maturities; we would consider this a good liquidity position, but only if the company were not close to being out of compliance on its loan covenants. Speculative-Grade Rating Refinements Our review has led to several revisions to our approach. The modifications are intended to enhance our current rating product--not to supplant it. Our three main goals are to: Enhance the quality of speculative-grade analytics, Provide greater transparency, and Improve timeliness. Enhanced analytics Shorter rating time horizons. For speculative-grade credits, we will place greater weight on near-term risk factors, generally looking out over a two-year time frame. Overemphasis of longer term (inherently less predictable) issues could lead to some distortion when opining on the risk level of a speculative-grade issuer. Although we believe that our enhanced analytics will not have a material effect on the majority of our current ratings, individual ratings may be revised. For example, a company with heavy debt maturities over the near term (especially considering the current market conditions) would face more credit risk, notwithstanding benign long-term prospects. Conversely, for companies that are currently well positioned, ratings would place less emphasis on competitive risks that are not particularly relevant in the near-term future. By giving greater weight to near-term risks, we feel there can also be a more appropriate level of clarity with respect to the key factors driving the rating. This does not suggest that we're completely disregarding future events, or that the rating opinion addresses different credit risks than before. When longer term factors are relatively predictable and material, we will fully factor them into the rating. Shorter rating outlook period. We're also shortening the time horizon for speculative-grade rating outlooks, to emphasize one year. The reason for this follows from the re-weighting of factors incorporated into the ratings themselves. This change also brings the outlook period within the expected holding period of many speculative-grade investors, and we believe that the shorter term outlook will be more predictive of rating direction. More focused business risk assessment. We will also enhance business risk assessments in order to better differentiate the level of business risk for speculative-grade credits. We will analyze these risks with the help of a newly developed risk matrix that should help evaluate the probability, impact, and time frame of risks and opportunities that may confront a company. This should enable us to give more weight to specific and relevant risks facing an issuer, and give less weight to generic and longer term vulnerabilities. For example, technology companies are generally associated with higher levels of business risk; so are companies of small size. However, the business dynamics of a particular niche may argue for Standard & Poor s RatingsDirect May 13,

7 placing less emphasis on the generic risk profile. The competitive risks in such instances, while possible, are less probable, and the rebalancing of these risks in the rating analysis could lead to a different rating outcome for a given company. Transparency Transition scenario analysis. Ever since we introduced rating outlooks for speculative-grade ratings some 22 years ago, they have been a popular tool for market participants. While investors have consistently pointed to the value of outlooks, they have also wanted specificity with respect to what might trigger a rating change. Investors have often asked about credit transitions; for example, "What will it take to move a particular 'B-' rating with a negative outlook into the 'CCC' category?" The inherent volatility that pertains to speculative-grade companies will always pose a challenge to rendering an opinion of future creditworthiness. We are exploring ways of modeling the impact of economic and business scenarios to present a higher level of detail about upside and downside potential whenever possible. Currently, we sometimes provide leverage or other financial triggers to signal potential rating actions. We will take this a step further by presenting some detail on business or financial scenarios that would likely lead to a rating change. For example, in a recent outlook statement on a 'B' rated company with a negative outlook, in addition to indicating that the rating would likely face a downgrade if interest coverage declined to 1.3x and/or debt to EBITDA approached 10x, we pointed to a 12% to 15% decline in revenues and a 350-basis-point decline in EBITDA margins as a scenario that would take the company to that critical point. Covenant compliance analysis. We will also provide a more meaningful discussion of covenant triggers and headroom. For example, a company may have a sizable unused bank line, but access depends on ongoing compliance with covenants. Often covenants tighten over time, and what constitutes compliance today may not be so 12 months from now. These considerations are important factors in rating conclusions, so spelling out our view of where a company is, or where we expect them to be, relative to key covenants will increasingly be part of our discussions on liquidity. A company may look to be in reasonable shape with debt to EBITDA at 7.9x against a covenant compliance metric of 8.25x, but if that metric steps down to 8.0x in six months, the cushion wouldn't be the same. Our plan is to provide this kind of analysis in our write-ups on speculative-grade issuers. Timeliness More dynamic surveillance. Placing greater emphasis on the near term is likely to result in a more dynamic model for speculative-grade ratings. Tweaking the analytical elements and focus should also make the ratings and outlook more responsive. The current market environment provides little leeway for companies with respect to turning around business reversals, and the ratings will appropriately reflect this heightened risk. Rating linkage to model scenarios makes for efficiency. Communicating the key factors that could lead to a rating change helps investors anticipate the potential impact of alternative future performance scenarios. Our use of scenario forecasting models helps us map out, in advance, the implications for rating level changes and makes the management of such changes more efficient. Going back to the example mentioned previously, by specifying that a 12% to 15% revenue decline would likely lead to a rating downgrade, the timing of any such rating action should coincide with the unfolding of that scenario. 7

8 Meeting The Demands Of A Changing Market The revisions that we are introducing in our approach to speculative-grade ratings, taken together, represent a product evolution--designed to better reflect the higher level of credit risk that is present in today's environment. This rating model, in our view, will be sufficiently nimble to address subtle changes in a company's credit profile on a timely basis. We believe that our revised approach to speculative-grade ratings will bolster transparency and provide more information relevant to today's leveraged finance markets. Standard & Poor s RatingsDirect May 13,

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