Decoding Credit Ratings: Expert Insights from Alex Griffiths
Welcome to our deep dive into the intricate arena of credit ratings. Today, we unravel this complex subject with the guidance of Alex Griffiths from Fitch Ratings, who joined us on the Corporate Treasury 101 podcast.
Wondering what a credit rating even is? We’ve got you covered. Are you curious about what goes on behind the scenes when agencies like Fitch decide the relative credit strength of a company? Oh, we go there. But that’s just the tip of the iceberg. For those new to the topic or even professionals looking for a refresher, you’re in for a treat!
So, what’s on the menu for this exploration?
- Understanding Credit Ratings: At its core, a credit rating is a simple measure. Think of it as a report card for companies or countries, indicating how likely they are to pay back their debts.
- Criteria for Ratings: Have you ever wondered how rating agencies decide which grade to give? We’ll uncover the major factors that come into play.
- The Role of Corporate Treasury: It’s not just about numbers. The corporate treasury department has a significant role in shaping these ratings. And yes, we’ll explain how.
- Interest Rates and Inflation: These two economic factors are like the weather patterns of the financial world. They can change the course of credit ratings in surprising ways.
- The ESG Challenge: Environmental, Social, and Governance (or ESG) factors are becoming vital today. But how do they fit into credit ratings? It’s a puzzle we’ll piece together.
And trust us, there’s a lot more to explore. By the end of this article, you’ll have a clearer picture of the credit rating landscape and its many intricacies. So, let’s dive in and get to the heart of it!
Alex Griffiths: Head of Corporate Credit Ratings at Fitch Ratings
Who is Alex Griffiths? You’ve likely heard of Fitch Ratings if you’re in the corporate treasury. It’s one of the big three credit rating agencies, right up there with Moody’s and Standard & Poor’s.
Alex is the Managing Director and the Head of EMEA Corporate Ratings. He oversees credit ratings in Europe, the Middle East, and Africa.
In his role, he gets into the nitty-gritty of what makes a company have a stronger or weaker credit risk profile for investors. So, if you’re confused about credit ratings, wondering how to make sense of them, or just looking to up your treasury game, this article is made for you. By the end of it, you’ll be viewing credit ratings through a whole new lens.
What is a Credit Rating, and Why Does It Matter?
Understanding what a credit rating is fundamental for any company, especially for the folks working in the treasury department. Alex Griffiths from Fitch Ratings explains that a credit rating is an expert opinion. It aims to predict how likely an entity or financial instrument—like a bond or a loan—is to meet its financial commitments. Whether you’re wondering if a company can repay its debts or fulfill its lease obligations, credit ratings come into play.
Key Aspects of a Credit Rating
- Opinion-Based: It’s not an absolute right or wrong; it’s an educated opinion about the future.
- Financial Commitment: It focuses mainly on loans and bonds, but sometimes even leases can be part of the evaluation.
- Terms of Investment: The rating also determines whether the company follows through on its promises, like agreed payment schedules. Deviating from these terms could trigger a default.
How Credit Ratings Impact Treasury Management
If you’re in the treasury department, your role is more crucial than you might think when it comes to Credit Rating. One of your big tasks is ensuring the company has diverse funding sources. And guess what? Some sources might only be accessible if your company has a credit rating. Specifically, international investors often want a credit rating before they invest in your company. It’s a way to meet eligibility criteria for investment indices where a lot of money is parked.
Building Trust with Credit Ratings
You might wonder why these ratings are so vital. Well, they help build trust in the financial market. Alex points out that credit ratings offer a neutral, third-party opinion that can level the playing field between the issuer and the investor. They even sometimes get to see confidential information from the companies they rate, which helps them make a more informed opinion.
Credit Rating and Risk Management
When understanding credit risk, think of your company as a ship on the sea. The rating tells you how sturdy your ship is compared to others. It’s not about predicting the sea’s behavior but evaluating how well your ship can handle it.
Relationship with Insurance Industry
Alex clarifies that while insurance companies are big buyers of bonds, the direct correlation between the two industries is limited. Insurance companies focus more on the risk of having to do a payout, while credit ratings offer a neutral evaluation of a company’s default risk.
Trust and Independence
In the end, the credibility of a credit rating agency hinges on its reputation for being unbiased and independent. If investors start doubting the agency’s impartiality, its value in the market diminishes. According to Alex, building and maintaining that reputation is a long-term commitment credit rating agencies like Fitch take very seriously.
How Does Fitch Create Credit Ratings?
Understanding credit ratings is crucial for treasury professionals, as these ratings impact a company’s borrowing costs and investment opportunities. According to Alex Griffiths, Fitch’s approach is grounded in two key elements: qualitative and quantitative analyses.
Understanding the Business: The Qualitative Aspect
The first step in Fitch’s rating process involves a comprehensive understanding of a business. Fitch uses over 50 navigators tailored for each sector to guide this analysis. These navigators break down what characteristics are essential for each rating level within a sector.
- Scale: One example of a critical qualitative factor is a business’s scale. The scale indicates how diverse a company is—both in terms of geographic locations and business lines. A larger scale often provides leverage in negotiations with banks, making it more of a two-way discussion than a unilateral decision by the lender.
- Sector-Specific Factors: Besides scale, other factors like “reserve life” in the oil and gas sector come into play. These factors are intricate and depend on the industry.
Crunching the Numbers: The Quantitative Aspect
Once they understand the business, Fitch examines key metrics to categorize it more closely into a rating category. The aim is to determine how stable a company’s cash flows and revenues are.
- Stable Cash Flows: If your company has stable cash flows, you can afford to take on more debt without the risk of defaulting.
- Volatile Business: On the other hand, if your business is volatile, you’ll likely be limited in the amount of debt you can manage.
Fitch prefers to look at cash flow generation rather than conventional metrics like debt-to-equity ratios, which can be misleading for various reasons.
The Final Rating
After evaluating qualitative and quantitative factors, Fitch arrives at the final credit rating. Importantly, their approach is forward-looking. They use forecast models refined during events like the 2008 financial crisis to project future credit metrics. So, they don’t just rely on last year’s numbers.
Real-World Application: Pandemic Response
When the pandemic hit, Fitch used this forward-looking strategy to assess companies’ liquidity and long-term recovery prospects. This cautious approach led to fewer knee-jerk downgrades, earning Fitch praise in the market.
How Credit Rating Agencies Determine Industry Benchmarks
When evaluating a company’s creditworthiness, there’s more to it than just numbers on a balance sheet. Alex Griffiths sheds some light on this intricate process.
Understanding the Factors Behind Ratings
You might think credit ratings are solely based on a company’s financial health. But according to Alex, it’s much broader than that. The credit rating process doesn’t just rely on financial statement analysis. Business analysts play a significant role alongside finance analysts. They dive deep into scale, entry barriers, and regulatory stability. For example, if we talk about an oil company, its reserves also come under scrutiny. The idea is to get a well-rounded view of the business.
The benchmarks that Alex’s team uses have been developed over two decades. They started by evaluating where initial ratings stood and noted the characteristics that generally made a positive difference. Over the years, they have honed these into “navigators” to guide their analysis.
The Intricacies of Mergers and Acquisitions (M&A)
If you’re keen on how M&A activities influence credit ratings, Alex Griffiths has some insights. Generally, M&A activities can improve a company’s operational profile. The acquired business might bring invaluable assets, skills, or market reach. But here’s the catch: How you pay for the acquisition matters.
Paying for a merger or acquisition in equity is usually the best-case scenario for maintaining a strong credit rating because it doesn’t involve taking on more debt. But if debt is used, that’s where things get complicated. The key lies in balancing how much the M&A boosts your operational profile against how much additional debt you’re taking on. Your credit rating may be hit if the scales tip too much towards debt.
How Corporate Treasurers Influence Credit Ratings
Alex Griffiths says the corporate treasury department is often at the forefront regarding credit ratings. This team is usually the first point of contact for credit rating agencies. But what can treasury professionals do to influence a company’s credit rating positively?
A Conduit for Information
Alex explains that the role of a corporate treasury department is much more than just dealing with finance and strategy. Treasury professionals bridge the credit rating agency and the rest of the organization. They are often responsible for providing insights into the company’s business model, merits, and other crucial information that impacts the credit rating. So, when the agency has questions, the treasury department gathers all the necessary data to answer them.
What do Companies and their Treasurers do to influence Credit Ratings
- Manage leverage: Higher debt loads are typically result in lower ratings.
- Diversify Sources of Finance: It’s not only about the amount of debt but where it’s coming from. Are you only relying on local banks, or do you have a mix of sources? This impacts your liquidity and, by extension, your credit rating.
- Maintain Transparency: A transparent relationship with the credit rating agency can pay off. Many issuers build a relationship of trust which includes informing the agency about any issues or major corporate transactions beforehand.
Does Company Size Matter?
You might wonder, “Do I only need to worry about this if I’m a big-shot company?” Rating Agencies like Fitch tend not to look at very small companies.
Understanding Credit Ratings and Their Scales
You probably hear much about credit ratings like AAA, AA, etc. You might wonder what all these letters mean and how they work. Alex Griffiths says these ratings are more than just an alphabet soup. They’re a way to gauge how risky it is to lend money to a company or government.
What is an Issuer Default Rating?
When people talk about credit ratings, they mean the “issuer default rating.” This term helps us understand the relative likelihood that a company won’t be able to pay back its debts. The term “issuer default” is focused on the chances of a company defaulting on its obligations. These look at a company’s future, not just what’s happening right now.
The Scale from AAA to D
The credit rating scale starts at AAA and goes down to D. Within this range, there are sub-categories with a “plus” or “minus” added for extra detail. For instance, BBB+ is better than BBB-. The ratings also help separate investment-grade companies from riskier ones, known as “sub-investment grade”. This split is set by everything with a rating below BBB- In the past, the sub-investment grade was called “junk,” but that’s not always fair today. Many reliable companies are in this category; they’re smaller or use more debt in their business strategies.
Not All Companies Aim for AAA
You might think all companies should try to get a AAA rating, but that’s not always the best path. Alex Griffiths notes that each country has its credit rating. Even if a company is a star performer in a low-rated country, it often won’t outshine the government’s rating. For such situations, “national ratings” offer more precise information within that country.
Sovereign and Business Ratings
Fitch and similar companies give credit ratings to both governments and businesses, and certain transactions. While the exact way they rate a government isn’t Alex Griffiths’s specialty, the processes share some similarities. Both look at factors like how well a group is managed and its financial standing.
The Importance and Impact of Credit Ratings on Companies
When dealing with a company’s finances, you know how crucial a credit rating can be. Alex Griffiths shared valuable insights into why credit ratings matter and how they affect a company’s financial decisions.
The True Significance of a Credit Rating
First, you may wonder what a credit rating is all about. Alex Griffiths says it’s not just a simple yes-or-no game for lending. A credit rating mainly affects the “price of the debt,” meaning the interest rate and terms you’ll have to deal with when borrowing money. These ratings offer independent opinions about a company’s credit risk, which investors find crucial for their decisions.
But here’s the kicker: credit ratings aren’t just for determining loan terms. Companies also use them in other ways:
- Supply Chain Management: To assess the financial stability of suppliers.
- Counterparty Risk: To measure the risk associated with various business partners.
- Internal Governance: For privately owned companies lacking market discipline, ratings serve as a third-party opinion on creditworthiness.
What Happens When Ratings Change?
Now, what if your credit rating goes up or down? Here’s where things get interesting. Don’t expect an instant party if your company’s rating increases. You might not feel the benefits right away. However, you could get better pricing terms the next time you issue a bond.
On the flip side, if your rating goes down, it doesn’t mean doom and gloom—at least not immediately. Most of the bonds in question have fixed interest rates, so the real impact comes when you need to refinance. Lenders may become less willing to lend again, especially if the market conditions aren’t in your favor.
If you’re a lender, things look a bit different. When a rating changes, it can affect your bond’s market value. For instance, if you bought a bond at a 5% interest rate and the issuer’s credit rating gets downgraded, the fair market value of your investment might take a hit.
So, to sum it up, credit ratings are more than just numbers. They are a versatile tool that both borrowers and lenders use for various financial and risk-assessment purposes. Keeping an eye on these ratings and understanding their implications can make a big difference in your financial strategies.
The Role of ESG in Credit Ratings
The significance of Environmental, Social, and Governance (ESG) factors in credit ratings is a hot topic these days. Alex Griffiths shed some light on how his company, Fitch, incorporates ESG into their credit ratings. So, let’s dive in and see what he had to say.
What are ESG Factors?
First things first, what is ESG? It’s a way to look at how a company is doing beyond just money matters. It covers things like how the company treats the environment, its workers and whether it’s run fairly and openly. Alex Griffiths mentioned that Fitch has been looking at these factors, especially governance, for a long time. They’ve always thought governance in particular is important, especially in emerging markets.
How is ESG Factored into Ratings?
In 2019, Fitch introduced something called “ESG relevance scores.” They wanted to show people how ESG factors into their credit ratings. They use a score from one to five. A score of one means an ESG issue, like airlines’ water usage, is irrelevant. A score of five means an ESG issue greatly impacted the rating.
These scores help Fitch and its clients better understand the role of ESG issues. Alex Griffiths mentioned that ESG issues influence about a quarter of all their ratings. And guess what? Governance issues is top the list, followed by social and then environmental issues.
The Long-Term Impact of ESG
Climate change is a biggie but tricky to measure because it’s a long-term issue. Fitch focuses on what will happen in the next three to five years. But climate change effects may take longer to show up. So, they came up with “climate vulnerability signals.” These range from zero to 100 and help investors know the risk today and years later.
Should Companies Be Penalized for Ignoring ESG?
Now, you may wonder if a company that doesn’t care about ESG should get lower credit ratings. Alex Griffiths explained that Fitch Ratings is all about credit risks. They stick to that. But they also have a part of the business that looks at the bigger picture of how companies affect the world, called “Sustainable Fitch.”
In a nutshell, Fitch Ratings wants to make sure they’re measuring what they’re good at—credit risk—while giving you a heads up on long-term risks like climate change. And while they keep their focus on credit, they’re aware that these broader impacts could become important down the road. So there you have it—the ins and outs of how ESG factors into credit ratings, straight from the expert’s mouth.
Understanding Investment Risks in Various Industries Due to Climate Change
Industries where Climate Policies Will Have a Neutral, or Positive Impact: Wind, Solar, and Electricity Networks
Wind and solar power experience only tailwinds from climate transition policies. Alex pointed out that his team focuses on “downside risk,” not necessarily the positive side. In the case of renewables like wind and solar, they might benefit from the transition away from fossil fuels. He emphasized that this doesn’t mean these sectors are risk-free. Each industry has challenges; however, regarding climate change, their risk is either neutral or positive.
The Complexity of Electricity Networks
A side note on electricity networks: they may face operational challenges. Alex shared his experience of installing solar panels on his roof. The network must adapt to manage these new inputs when many homes generate electricity. In other words, it’s not just a one-way street anymore. There is a need for investment in these networks, but because such companies often earn based on their investments, they are likely to fare well, assuming regulatory and public support remain solid.
Risky Industries: Oil and Petrochemicals
Conversely, oil production and petrochemical industries show a rise in vulnerability over time. These sectors are becoming increasingly exposed to the risks associated with climate change, posing risks to creditworthiness which companies will have to work to mitigate.
The Grey Area: Cement Industry
Alex added an intriguing twist about the cement industry. While cement is responsible for nearly 10 per cent of the world’s CO2 emissions, it is also crucial for building infrastructure, especially preparing for extreme weather due to climate change. The demand for cement is so constant that the industry can likely pass any extra costs back to the consumer.
Alex Griffiths’s team handles the uncertainty of future conditions by focusing on a specific scenario. They use the UNPRI’s inevitable policy response to gauge how different sectors might adapt. This approach helps identify risks in extreme cases like renewables, coal, and industries that fall somewhere in between, like cement.
Understanding ESG Ratings and the Role of Treasurers
Treasury professionals should be well-versed with ESG (Environmental, Social, Governance) ratings to stay ahead in today’s rapidly changing business landscape. Alex Griffiths provides his observations on the characteristics he sees in the most effective teams.
Integrating ESG in Treasury Decisions
- The Importance of Integration: The effectiveness of a treasurer in addressing ESG largely hinges on how well they’re integrated with their company’s overall approach to ESG.
- Collaboration: If there’s a sustainability leader in the company, treasurers should closely align with them. This ensures that when facing external parties like investors, everyone can confidently discuss ESG matters.
- The Changing ESG Landscape: Gone are the days when anyone in a company could consider ESG as someone else’s concern. ESG is now a collective responsibility.
- Transparency: Alex emphasizes that the best teams he’s worked with have been transparent. For instance, a company transitioning to greener methods should be upfront about the costs and timelines.
Emphasizing the Governance in ESG
- The Role of Internal Governance: The “G” in ESG pertains to a company’s internal governance. It’s where businesses can exert the most influence. Proper governance also reflects a company’s commitment to sustainability.
- The Treasury’s Place in Governance: While it plays a governance role, the larger structure envelops it. Good governance usually indicates a disciplined and professional treasury.
- Effective Treasury Management: Alex points out that while the broader governance of a company can impact its ESG ratings, the treasury function has its part to play. A strong treasurer will:
- Clearly outline and follow their policies
- Communicate these policies effectively
- Understand and discuss the wider governance structures in place
So, being a treasurer is not just about managing money; it’s also about taking an active role in your company’s ESG strategy and governance. If you do this well, not only will your company be in a better position, but you’ll also be a star in your role.
Challenges of Incorporating ESG into Credit Rating Scores
The journey is not always smooth when incorporating Environmental, Social, and Governance (ESG) factors into credit ratings. Alex Griffiths sheds light on the hurdles and how they navigate them.
Time Horizon: A Delicate Balance
A key challenge is balancing the time frame for the impact of ESG factors. Climate change, for example, is a long-term issue, but credit rating agencies typically focus on a three to five-year outlook. Fitch Ratings uses what they call a “vulnerability signal” to identify problems that may arise in the future, say 15 years down the line. This allows them to adjust their ratings if early indicators of these issues become visible, even if they haven’t impacted their ratings yet.
Politics and Policies: The Moving Targets
A unique hurdle comes from political decisions, especially those that pertain to climate policies. Alex mentions the “Paris Ratchet,” an agreement where governments will reassess their policies to meet the Paris climate goals. If policies are lacking, they will be ramped up by 2025. Because these changes can happen rapidly, thinking ahead is crucial rather than adopting a “wait and see” approach. You might be unprepared for quick, policy-induced changes if you don’t.
The Danger of Ignorance
According to Alex, the biggest obstacle is ignorance—simply not paying attention or missing out on crucial information. The need for awareness has never been greater, especially as policy changes are expected to come quickly.
This. canbe addressed by monitoring long-term ESG trends and preparing for rapid policy changes. You don’t want to be caught off guard when the policies shift and the risks you’ve postponed become today’s emergency.
How Do Interest Rates and Inflation Impact Credit Ratings?
How do interest rates and inflation affect credit ratings in a world where the economy keeps everyone guessing?
The Market’s Role
First off, the market is a little lost right now. Why? Because interest rates are rising, and that changes how people decide to lend money. Alex points out that if you’re someone that borrowers like, you will face higher charges. On the other hand, if the market doesn’t know you well, you might find it difficult to borrow at all.
The Influence on Borrowers
Now, if you’re a company that relies on floating rate borrowing a lot, you’ll feel the heat even more. Most big companies deal in fixed rates, but smaller ones often rely on floating rates. Imagine you’ve borrowed a lot, and the rates suddenly shoot up; your repayments will skyrocket, too. So, companies burdened with hefty floating-rate debts are finding it tougher to manage.
Operational Side of Things
According to Alex, since COVID-19 hit, things haven’t gone back to normal. Big companies that don’t rely much on everyday consumers are doing okay. They can pass on the rising costs to their prices. But companies that depend on discretionary consumer spending? Many are in a bind. Because people are cutting corners right now, they’re more worried about paying for essentials like electricity rather than splurging on a new wardrobe.
What About Debt and Timing?
Refinancing risk is becoming a bigger rating consideration. Some companies borrowed a lot of money back in 2021. That’s good for them because they don’t have to worry about paying it back soon. But others with high debt loads who couldn’t refinance then, often in consumer-facing sectors hit hard by COVID-19, can have a tougher time accessing the market.
To sum it up, if you’re a company with low debt and not much reliance on consumers, you’re probably doing fine. But if you’re weighed down by debt rely heavily on consumer spending, and need to refinance, you may be walking on thin ice. It’s a world of difference, and understanding these nuances is essential for planning your next moves wisely.
Adapting to Market Volatility: How Ratings Agencies Keep Up
When economies take a hit, ratings agencies like the one where Alex Griffiths works have a tough job. They must update their ratings for different industries to reflect the new realities. Alex shared how his agency navigated these uncertain times, especially during the COVID-19 pandemic and the Russian gas crisis.
Keeping Up with Industry-Specific Rebounds
Alex mentioned that despite the general feeling of volatility, the last year has felt more like “quasi-stagnation.” However, some industries have rebounded better than others. For example, the travel industry is booming again, with flights now often overbooked.
Addressing Short-Term Concerns: The Russian Gas Crisis
One of the big concerns last year was the Russian gas situation. Europe relies heavily on Russia for its gas supplies. The initial predictions were dire, suggesting as much as a 10% dip in Germany’s GDP if Russian gas were turned off. That’s a huge deal, almost like the sky falling.
Alex’s team dug deep into the situation, looking at:
- Where the gas pipelines are
- Where additional gas could come from
- What policies governments might implement
- Which companies are more prepared to handle the situation
After doing their homework, they talked to many corporate treasurers to understand their plans. They found that larger companies, typically those that issue bonds, had better-prepared plans and greater flexibility. This led to only limited changes in their ratings.
When Crisis Becomes Routine
Alex makes an interesting point: not every crisis fundamentally changes how they approach ratings. Even with significant events like a pandemic or a sudden gas crisis, the basic principles of analyzing cash generation and borrowing remain the same. They deal with these crises by deeply understanding them and taking appropriate action.
So, it’s not about completely rewriting the playbook whenever a new issue arises. It’s about staying grounded, doing the research, and adjusting your strategies as needed. Sticking to basics and analyzing the situation can go a long way, even in an uncertain world.
How Recent Banking Failures Impact Corporate Credit Ratings
The banking landscape has been volatile recently, with several American banks and Credit Suisse in Europe facing significant troubles. So, you might wonder how these events impact corporate credit ratings.
Extended Period of Uncertainty for Corporates
According to Alex, these banking setbacks have extended the period of uncertainty in the corporate world, particularly in Europe, extending the period it is taking for debt markets to recover. Companies were already dealing with several issues, such as disruptions in Russian gas supplies.
- Rate Peaks: Companies are still figuring out when rates will peak.
- Idiosyncratic Banks: The impacted banks in the US were unique cases and seem to have been contained.
- Spreads: There’s a slight difference between the rates for financial and non-financial borrowings, but it’s not alarming.
Low Impact on Big Corporates
The good news is, according to Alex, that bigger companies were generally less affected by these banking issues. Why? Because people usually turn to these giants when there’s a financial shake-up.
- Flight to Safety: Big firms serve as a haven for investments, minimizing their borrowing risks.
- Risk to SMEs: Smaller businesses face a higher risk of reduced lending willingness.
European Context: The Case of Credit Suisse
So, what if a significant European bank like Credit Suisse fails? While such a failure does create panic, its impact on corporate ratings has been minimal.
In our exploration of credit ratings with insights from Alex Griffiths of Fitch Ratings, we’ve delved deep into the intricate world of credit assessment. From understanding the fundamentals of credit ratings as expert opinions predicting financial commitments to deciphering the qualitative and quantitative aspects that shape them, we’ve unveiled the multifaceted dimensions of this crucial financial realm.
We’ve learned that credit ratings aren’t just numbers but vital tools that influence companies’ borrowing costs and investment decisions. The corporate treasury department, often the unsung hero, plays a pivotal role in shaping credit ratings through transparent interactions with rating agencies. Transparency, proactive management, and a trust-based relationship with agencies ensure accurate evaluations that enhance the company’s credibility in the financial market.
As we navigated the intricate landscape of ESG factors and their influence on credit ratings, we realized the expanding significance of Environmental, Social, and Governance considerations. ESG relevance scores have clarified the impact of these factors, driving the sustainability conversation. With climate change looming large, industries are diversely affected, and understanding their vulnerabilities is crucial for long-term investments.
We’ve comprehended how interest rates, inflation, and unforeseen crises like the Russian gas situation impact credit ratings in a world of market volatility and changing economic conditions. The resilience of rating agencies in adapting to uncertain times while adhering to fundamental principles is a testament to their ability to navigate even the most challenging situations.
If you’re curious about how credit ratings work, Alex suggested visiting their website, fitchratings.com. Whether you’re a treasurer or interested in the financial market, you can find useful information and contacts there.