Jacphanie Cheung , Associate, Corporate & Infrastructure Ratings, Standard & PoorÆs
Institutional investors have beaten a path to the high-yield market in ever-larger numbers over the past few years, but they'll need to keep a close eye on credit risks. Standard & Poor's default studies show that when things go wrong, this type of asset class can fall into a distressed situation much more quickly than investment-grade credits.
Standard & Poor's applies similar analytical methods to all credit classes, but minutely scrutinizes several areas of particular concern for high-yield, or "speculative-grade", credits, such as cash flow, liquidity and liability risk management, and structural issues. It also applies stress scenarios to expose potential funding gaps and dissects complicated corporate structures for cash flow leakages. This article explains the key tools that Standard & Poor's uses to analyze and keep close surveillance on companies in this popular, but risky, credit category.
Cash Flow -- A Useful Guide To Debt Protection
Analyzing cash flow is critical for speculative-grade-rated companies, as these companies tend to have volatile financial positions and need to use cash rather than earnings to meet interest and principal payments. Despite the strong relationship between cash flow and earnings over the long term, cash flow is a better measure of debt protection over the near term, as it is subject to fewer accounting manipulations and can highlight potential cash leakages.
Standard & Poor's frequently uses funds from operations as a general measure of a company's cash flow from operations. For start-up, high-growth, or trading companies, however, free operating cash flow may better reflect cash flow positions, given these companies' need for high working capital and capital expenditure. Start-ups include Mandra Forestry Finance Ltd. (B/Stable/--), a forest plantation company operating in China, while high-growth companies include Thailand's G Steel Public Co. Ltd. (B+/Stable/--) and Indonesia's PT Gajah Tunggal Tbk. (B/Stable/--), which plan large capacity expansion over the next few years. Despite generating positive funds from operations, companies like these consistently generate negative free operating cash flows because investment is needed to support growth, resulting in increased external financing. Specific cash flow ratios to be considered include:
ò The ratio of free operating cash flow to interest
ò The ratio of free operating cash flow to total debt
ò The debt payback period (ratio of total debt to discretionary cash flow)
Watch out for distortions
Cash flow analysis has its limitations, however. Cash flows can sometimes be lumpy, requiring a close examination of their components and nature. Some cash flow items may need to be reclassified when calculating financial ratios. For example, repayment of shareholders' loans from subsidiaries or associates may be a common recurring cash inflow item for some companies. While similar in nature to dividend payments, such items may not necessarily be classified as operating cash flow. Cash flow ratios including these repayments can be significantly different from those without. Cash flows also do not take into account qualitative aspects, such as a company's financial flexibility.
Stress Scenarios -- Spotting The Likelihood Of Funding Gaps
To assess downside protection levels, Standard & Poor's reviews financial projections from companies, scrutinizes the reasonableness of assumptions, and applies various sensitivity scenarios to determine the likelihood of funding gaps that may lead to defaults. For instance, a price-sensitivity scenario may be appropriate for companies that face volatile business cycles or with limited pricing power in the market.
Such tests could include historical medium-term average prices. However, historical price cycles may not reflect price trends over the next business cycle resulting from fundamental changes in industry conditions. For instance, historically high prices resulting from tariff or regulatory protection may not be sustainable.
As product prices of steel companies, for example, have stayed above international market prices, the price premium would be removed in stress testing. For high-tech companies, such as Taiwan's Ritek Corp. (B+/Stable/--), a stress test is likely to involve changing average selling prices and capital expenditure. This reflects the short product cycle for this industry and the high capital needed for research and development.
For a commodity producer, such as PT International Nickel Indonesia (BB-/Stable/--), historical medium-term and low prices/rates, as well as a cost breakeven analysis, will probably be applied, as the lowest cost producers are more likely to survive the next downturn in a business cycle. If companies face significant start-up risks, such as Macau casino operator Galaxy Casino S.A. (B+/Stable/--), a stress scenario could include delays to the company's implementation plan, construction setbacks, and cost overruns.
A similar stress scenario is applied to companies rapidly expanding their capacity, such as Singapore's Continental Chemical Holdings Ltd. (B+/Stable/--), which plans to build a large production facility in China. Other typical stress scenarios may involve interest rate changes, foreign-exchange fluctuations, a slowdown in sales, and cost increases.
Liquidity, Liability Risk Management û Why Contingency Planning Is Important
Liquidity and liability risk management is carefully analyzed to determine how well a company can weather downside scenarios. Investment-grade companies generally have ready access to external financings, such as undrawn committed bank lines to cover temporary cash shortfalls; but speculative-grade issuers may lack this flexibility. Standard & Poor's evaluates a company's minimum cash policy to see whether it could cover maturing short-term debt. It also considers a company's capital-expenditure plan and level of non-discretionary capital expenditure, debt characteristics such as undrawn committed bank lines, maturity profile, hedging policy and the resulting exposure to interest rate and foreign exchange fluctuations, financial covenants, short-term financial investments, and other liquid assets.
Typically, high-yield issuers face more structured covenants compared with investment-grade issuers, limiting the type of activities in which they can engage. Common high-yield covenants include:
ò Limitations on incurring additional debt
ò Restrictions on dividends
ò Restrictions on asset sales
ò Restrictions on change in control
ò Limitations on guarantees
ò Financial maintenance tests
If there are rating triggers in the covenants, which are seen mainly in investment-grade companies, a potential credit cliff could occur upon a credit downgrade to a speculativeûgrade category, as demonstrated by the well-known bankruptcy of Enron Corp. in the U.S. a few years ago. Standard & Poor's also identifies potential calls on cash, such as litigation, obligations arising from derivatives, and other contingent liabilities that could strain liquidity.
Structural Issues -- Bond Ratings Factor In Recovery Prospects
Standard & Poor's issue ratings factor in recovery prospects for creditors as well as the potential for default. As such, the rating on a bond issue may sometimes be notched below (or above) the rating on a company. Standard & Poor's pays particular attention to structural issues when rating high-yield companies, as they tend to have more secured debt (as required by their lenders).
If the level of secured debt becomes material, unsecured creditors will have a lower priority when making a claim after a default by the company, resulting in lower recovery prospects. In this situation, the rating on an unsecured issue would be notched below the rating on the company to reflect its subordinated claim. However, such notching may not be applicable in countries where the enforceability of lenders' rights is weak, such as India, the Philippines, and China.
The $400 million senior unsecured bonds issued by Hong Kong-based Titan Petrochemicals Group Ltd. (Titan) in March 2005, for example, were rated 'B+', one notch below the 'BB-' corporate credit rating on Titan. Similarly, the proposed $225 million senior unsecured bonds issued by Thailand's True Corporation Public Co. Ltd. were rated 'B+', two notches below the 'BB' corporate credit rating on the company. The differences between the ratings reflect the companies' high level of secured debt, which means the secured creditors have a significant priority claim on the company's assets.
In addition to secured debt, unsecured creditors face more frequent structural subordination with speculative-grade companies, as bankers tend to prefer to lend to operating subsidiaries that hold operating assets. Structural subordination may arise when substantial priority liabilities exist at the company's operating subsidiaries. If Standard & Poor's determines that a company's unsecured creditors are likely to have a materially lower priority claim relative to unsecured creditors at the operating subsidiaries if it defaults, then the issue rating will be notched below the company rating.
Chinese Future Corp. (Chinese Future), for example, is rated 'BB' while its $225 million senior unsecured notes due 2015 are rated 'B+'. The rating on the issue is two notches below the corporate credit rating because the senior unsecured notes are structurally subordinated to substantial bank debt held by the company's operating subsidiaries.
Complicated Corporate Structures -- Transparency Can Be An Issue
Investors need to be wary of high-yield companies that have complicated organizational structures. These structures could be a legacy of family holdings or reflect the early stages of corporate restructuring, or for other purposes, such as tax optimization. Investors should particularly watch out for excessive asset transfers between group companies, especially between privately owned entities.
The complexity of these structures may make transparency an issue and result in weaker control of cash flow. For example, cash could be trapped in the operating subsidiaries instead of flowing upward to support the parent, or vice versa, in times of distress. Setting up effective covenants under such complicated corporate structures can also be complex, potentially weakening protection for creditors.
Funds held by the Indian subsidiaries of U.K.-based Vedanta Resources PLC (BB/Negative/--), for example, could be transferred in the form of dividends or to service related company loans, according to Indian regulations. Failure to access these funds could affect the company's overall debt repayment ability. Furthermore, lenders to the weaker subsidiaries should be aware that parental support may not be available when needed as the complicated corporate structures can isolate risk between the parent and subsidiaries.
Monitoring And Surveillance -- Close Contact Avoids Distorted Perspective
Monitoring and surveillance are especially important for high-yield companies as they tend to operate in more volatile business environments and/or have weaker financial positions. Changing industry conditions could exert pressure on a company's liquidity position over a short period. While interim results announcements during the year provide useful information on a company's financial position, these results are historical in nature, and many companies do not report on a quarterly basis.
To keep pace with their latest developments, Standard & Poor's maintains regular contact with high-yield issuers. For companies with start-up operations or with major projects under construction, Standard & Poor's keeps track of the timing of major milestones in order to spot potential delays and cost overruns.
Early warning of potential problems can sometimes be highlighted by irregular stock price movements and/or bond spreads, reshuffling of senior management, and even market speculation. However, Standard & Poor's always clarifies with the company the reasons for these potential warning signals and independently determines the rating impact, if any -- a measured approach that underpins its careful analyses (see sidebar).
Sidebar: Ratio Medians
For more than two decades, Standard & Poor's has been publishing financial ratio medians, which are statistical composites based on historical performance (see table below). They are not rating benchmarks because many non-numerical distinguishing characteristics can determine a company's creditworthiness. Rather, they are intended to convey ranges that characterize levels of credit quality as represented by the rating categories.
[The article is an extract from RatingsDirect, Standard & Poor's Ratings web-based credit research and analysis system (www.ratingsdirect.com). To learn more, please click on About RatingsDirect.]