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We are always interested in speaking to members of the media on news and events affecting the world of corporate credit risk. We look forward to hearing from you.
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Credit Raters Blase About Junk Cos Stock Price Surge
Source: Dow Jones
Date: March 25, 2004
Author: Simona Covel
NEW YORK (Dow Jones)--If investors had filled a stock portfolio with junk-rated companies one year ago, they could have earned a 74% return - the median change in market value for a high-yield company over the last 12 months.
As a result of the spectacular rise, those companies may look like they're worth more. But not to the ratings agencies. As far as they are concerned, junk is junk, and without other indications of improved creditworthiness, the fact that the stock market values them so much higher is of little importance. Other analysts in contrast believe that the stock price is a useful barometer of a company's health.
It comes down to the fact that in the corporate bond world, no one seems to quite know what to make of stock prices. The ratings agencies are aware of them, but prefer to focus on what they call "fundamental factors," like leverage ratios. Bond analysts are split on their importance, mentioning rising or falling equities when there seems to be a correlation to the bond world and ignoring them when there doesn't. And in a few cases, specialized analysts claim that stock prices are actually an accurate measurement of potential risk.
"People are very enamored of the relationship between stock prices and bonds," said Martin Fridson, publisher of industry publication Leverage World. "As long as there have been screens, (traders) have kept stock prices on the screens."
But he and some others believe that a causal relationship between the two is dubious. That view is especially potent among the traditional ratings agencies.
While "there's a possibility that stock price changes might be correlated with movement in a firm's underlying credit fundamentals," said Richard Cantor, a managing director for credit policy research at Moody's Investors Service, there isn't "a direct impact on analysis."
Instead, said officials at all three major credit rating concerns - Moody's, Standard & Poor's and Fitch Ratings - leverage and a company's ability to raise cash remain among the most important criteria in determining its rating. That helps to explain why over the course of 2003 (2004 data aren't yet available), as stock prices for high-yield companies were charging upward, high-yield downgrades actually outpaced upgrades by a ratio of almost two-to-one, according to Moody's.
A high stock price, of course, could be fueled by any number of factors and doesn't preclude a company from remaining highly levered - and that's where the conflict arises.
It's About Liquidity
Stock prices, though, must be reacting to something, say those who take them into account when determining projected default rates. People buying stock clearly don't do so when they believe a company is on the verge of collapse.
That's the tenet that underlies several credit default models. "You can think of the stock price as an important indicator of credit risk for a company," said Edward Altman, a professor at New York University's Stern School of Business and creator of the Z-score default model, which takes into account the market value of equity relative to liabilities. "The higher the stock price, the lower the cost of equity capital," said Altman. "It's consistent that stock price increases reduce the probability of default."
Analysis from Moody's KMV, a subsidiary of the ratings agency, takes the connection even further. KMV's model to determine expected default frequency uses the current equity price as a proxy for asset value and considers stock volatilities.
Right now, said Tim Kasta, a managing director at KMV, the median default probability in high yield is 86 basis points compared with a five-year peak of 4.6% in November 2000 and a rate nearly that high in October 2002. That means that in November 2000, for every 100 high-yield companies, Moody's KMV expected four to five to default. Today, the number has declined to less than one - and that's partially because of the companies' collectively strong stock prices.
Kasta agreed with officials at his parent company that despite stock euphoria, the issuers still may be in danger. Even though in his model the leverage ratio is reduced because it incorporates the stock price, he acknowledges that for some of these companies, debt levels remain high. According to the KMV model, "leverage went down, but not due to debt - due to change in the market value as evidenced by the stock price," said Kasta.
The ratings analysts too concede that a strong stock price - even if driven by irrational or macroeconomic factors that won't affect credit ratings - can improve an issuer's access to the capital markets, allowing a company, to issue more stock or access the debt markets more easily.
"We look at it if it has a direct bearing on liquidity," said Nick Riccio, a managing director in corporate ratings at S&P. "We make a call more on the company's prognosis for business."
And the stock price, of course, isn't always an accurate measurement of that prognosis. Just consider the inflated share prices of the recent spate of bankrupt companies.
"The market was riding high before 1999, and that was right before the largest credit quality contraction since the depression," said Mariarosa Verde, a managing director for credit policy at Fitch Ratings.
Indeed, the experience of the millions of investors who suffered from the huge bankruptcies of the last four years is emblematic of the unreliability of stock prices as a measure of a company's health.
Then again, the ratings agencies weren't too quick to downgrade those issuers either - prompting widespread criticism that the so-called "fundamental" factors that the ratings companies measure can be just as unreliable as equity prices.
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