Perceived credit quality and risk exposure
For purposes of risk management bonds are often grouped according to agency ratings based on the assumption that bonds with similar ratings tend to show a high degree of comovement. Breger et al. (2003) examine whether the correlation between individual bonds increases if they are grouped by implied ratings, that is by spread classes rather than by agency ratings. The rationale for this would be that market valuations are a better indicator for the drivers of credit spread changes, namely perceived credit quality and risk exposure, than are agency ratings. In their empirical study they find that bonds of the same spread class are more similar than bonds with the same rating from a risk/return perspective. Breger et al. (2003) conclude that the classification of bonds based on market data provides a more reliable basis for modeling return relationships than does a classification by agency ratings. However, one has to note that the motivation behind this study differs significantly from the rating agencies’ approach. The objective is not to predict default risk, but rather to improve the classification of corporate borrowers and provide a basis for reliable spread risk forecasts.
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.
A currency mismatch between credit and revenues
Transaction risk arises when a company has a currency mismatch between its costs and revenues, that is, revenues are generated in one currency while costs are denominated in another, the reporting currency. The sustained depreciation of the US dollar since February 2002, for example, has negatively affected the P&L and cash flow statements of European exporters.
Although it proves difficult to obtain a breakdown of the cost structure of a company by currency, the automotive sector and the aerospace sector seem to be hit most by transaction risk.
Therefore, many companies try to offset at least a part of their currency exposure via natural hedging. That is, they try to match currency flows that result from exports and imports of goods and services. A high degree of flexibility with respect to input factors and capacity utilization of plants in different regions also provides an effective hedge against adverse currency movements. Another possibility of reducing currency risk is through derivatives, primarily forward exchange contracts and currency options. In our experience most companies that are significantly exposed to currency risk use some form of derivatives hedging. Yet, most contracts are set up for a period of 1–2 years at most. In the long term, it is difficult for companies to assess their demand for hedging because they have no reliable information
about the future demand for their products and services so that the future cost and earnings situation is unknown. For longer term trends in exchange rates, natural hedging usually is more effective. Credit analysts often lack a thorough insight in currency hedging strategies, especially with regard to derivatives hedging. Since they are hardly able to assess the true currency exposure in the short term, they tend to prefer the longer term and more transparent natural hedging strategies.