Don’t be affraid of credit changes
Through openness and a future orientation an organization can begin to take a realistic look at its culture. By doing this self-analysis, it begins the process of healing the wounds caused by a past orientation. The bad news is that the journey toward openness and a more positive paradigm takes time. The good news is that you can start right now. And you don’t have to go through the experience alone. You can use the Partnership Continuum as a guide to increase your Partnering Intelligence and get you to your destination.
Change is part of our daily lives. Our bodies go through a normal growth and maturity cycle as we change from children to adolescents and then to adults. As our bodies develop, we also mature both mentally and emotionally. Change doesn’t end with our bodies and minds. It is a dynamic that affects our relationships as well. And to add to the complexity, people are changing in different ways and at different rates all the time. As Heraclitus noted, there is nothing permanent except change. With all this change occurring around us, it’s helpful to remember that while you can’t always control change, you can control how you respond to it.
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.
The impact of credit on operating income
The paper sector is only mildly exposed, since in general companies generate no more than 20 percent of their revenues in the United States. The more internationally oriented technology and chemical companies like Siemens, Philips and Akzo generate about 30 percent of sales in the United States, and have substantial further sales outside the Euro area. Yet, the impact on operating income is reduced by the fact that a significant part of costs accrues in US operations. Additionally, most industrial companies engage in hedging activities. Among the companies with a high exposure to currency risk are UK companies FKI and Pearson that both generate more than 60 percent of sales in the United States. When the US dollar depreciates significantly, these companies are hit hardest.
With respect to their vulnerability against currency movements, companies from the consumer sector benefit from their broad geographic diversification.
It appears to be common policy to match assets and liabilities in the various regions to minimize overall currency risk. However, while transaction risk is accounted for, companies tend to leave translation risk unhedged. But many of the well-known European consumer companies like Nestle and Unilever have been able to raise funds in US dollars. Thus US dollar denominated debt exceeds assets and earnings. During the US dollar weakness those companies have seen their debt and interest burden diminish faster than their earnings. UK tobacco companies tend to finance a significant part of their business with Euro denominated debt, leaving them exposed to a strengthening of the Euro versus Sterling.
Loans are particularly exposed to currency movements
Being one of the most global sectors, the automotive sector is particularly exposed to currency movements. Significant changes of major exchange rates therefore may have a material impact on earnings. Yet, some manufacturers are better positioned than others due to a number of factors that do not only relate to natural or derivatives hedging. Awell-filled model pipeline, restructuring plans, cost reduction issues and a high degree of flexibility in the use and sourcing of raw materials and intermediate goods may outweigh negative effects due to currency fluctuations. With regard to transaction risk, those companies that have no foreign exchange exposure or are hedged, either naturally or through derivatives, clearly have the lowest risk. In terms of translation risk, companies whose assets and liabilities are well matched have the lowest risk and will have the lowest volatility of operating profits.
During the 2002/03 US dollar weakness, revenues and to a lesser extent operating profits of most European industrial issuers suffered significantly due to substantial US operations. However, exposure to US markets varies across industries.
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.