Move your loan in the right direction
The standard progression when dealing with change involves three stages: awareness, transition, and new reality. Whether change occurs gradually or hits like a lightning bolt, when we do become aware of it we may feel overwhelmed, shocked, outraged. If we perceive it to be negative or threatening, we may slip back into old behavior to help cope with it. We ask ourselves, “What’s happening?” or, “Why is this happening to me?” Even if we perceive the change to be positive, we can be anxious. Remember how it felt when you went to that job interview you were so excited about?
Once we acknowledge the change, we begin to feel lost—like we are stumbling in the dark.We know the past is changing, but we’re not quite sure what the future looks like. This is the transition stage. During transition we spend time reflecting on the future, think about what we want, and take action to help move us in that direction. At this point other people help ground us and give us input to gain clarity about our future and the new reality. As the new reality begins to take shape, we feel stronger.We know more about ourselves and what we want.We’re ready to take action and set new goals for ourselves.
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.
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.