Downgrading your loan is a good solution
The addition of the individual contributions to expected excess return in Experience yields an expected 1-year excess return of 88.2 bp for A-rated corporate bonds with a maturity of 5-years. This is significantly below the initial spread of 100 bps. The difference reflects the fact that a downgrade is more probable for A-rated corporate bonds than an upgrade, and that the associated spread changes are not symmetric. The magnitude of spread widenings due to downgrades is usually much higher than the spread tightening after rating upgrades. It is interesting to note that among investment grade bonds the ratio of upgrades to downgrades is most favorable for Baa-rated bonds. However, in the case of a downgrade these bonds often suffer massive price declines, because they fall below investment
grade levels.
Credit exposure to foreign currencies
European telecom companies have their operations primarily in Europe. Therefore, exposure to foreign currencies is very limited with the exception of Telefonica’s exposure to Latin America and Deutsche Telekom’s US subsidiaries. While in other industries an appreciating Euro increases competition, it appears that this effect should be negligible for the established European telecom services companies. The barriers of entry seem to be high enough to guarantee broadly stable market shares in the coming years. Since many of the telecom companies have a material fraction of their debt in US dollars, they would benefit from a strengthening Euro.
It is in the nature of financial institutions to have exposure to a variety of currencies. Exchange rate risk is therefore translational rather than transactional. By and large, long-term currency risk is primarily taken in the form of subsidiaries. Currency fluctuations change the value of the equity invested, hence are reflected in the balance sheet rather than in the P&L. Of the larger European banking groups, ABN Amro, BNP Paribas and Royal Bank of Scotland have substantial retail banking operations in the United States. In the insurance sector, Aegon, AXA, ING Verzekeringen and Prudential stand out in terms of US exposure.
Credit affected by fluctuations of exchange rates
Credit spreads are also affected by fluctuations of exchange rates, with the USD/EUR exchange rate being the most influential one. The depreciation of the dollar that started in 2002 could potentially affect European corporate issuers if it slows economic growth and reduces demand for their products.
However, a rise of the euro against the dollar could move the ECB to cut rates and thus would impact credit spreads via the interest rate channel. The dollar weakness is mainly due to a large current account deficit, low levels of interest rates and slowing equity capital inflows. Of course, sustained fluctuations of exchange rates can impact the business of corporate borrowers as well as financial institutions. While this does not necessarily lead to significant changes in credit quality and subsequent rating actions in the short term, especially companies with a weak financial profile may find the currency issue an unwelcome challenge. A forward-looking active currency management may be based on three main factors: US inflation, European growth and comments from policymakers. However, many companies are not able or willing to manage their currency exposure actively. In this case, significant changes in exchange rates will affect companies in three ways: via transaction risk, translation risk and import competition risk.