Where Credit Is Due

A new study of the largest issuers of corporate debt shows that recent gains in creditworthiness are more fragile than you think.

Unless you’re willing to bet that stock prices bear little or no relation to corporate financial strength, you’re wise to take the recent improvement in the capital markets with a large grain of salt. In fact, a new study shows that major issuers of corporate debt have not shored up their balance sheets as much as is widely believed.

To be sure, other signs suggest that corporate creditworthiness has improved dramatically in the past year or so. The gap between yields on investment-grade corporate bonds and those on Treasury securities has narrowed since the beginning of 2003 from 181 basis points to 111, according to Lehman Brothers. Spreads on derivatives known as credit-default swaps have also shrunk, recently hitting a 17-month low, according to one model. And while more than three times as many nonfinancial U.S. companies have seen their credit ratings downgraded as upgraded by Standard & Poor’s this year, the rating firms rating agencies are purposely slow to revise their opinions.

Wall Street, in short, is clearly more sanguine about companies’ ability to pay their debts—which is welcome news to finance executives who have seen a fall in their companies’ stock prices call into question the virtues of financial leverage. “During good times, leverage really helps the equity holders,” observes Paul Saleh, CFO of Nextel Communications Inc., the Reston, Virginia-based wireless-service provider. “But during down times, leverage becomes a limiting factor in the ability of the stock price to advance.”

Yet investors might not be so optimistic if they took a closer look at credit trends. The reason corporate creditworthiness has improved is not that companies have made great strides in paying down or refinancing their debt. That conclusion is based on a study for CFO magazine of the 100 largest North American issuers of debt by credit research firm Moody’s KMV (MKMV), a subsidiary of Moody’s Corp.

Instead, the improvement in credit quality reflects higher stock prices and lower asset volatility, the study indicates. How so? Simply put, corporate leverage is determined by trends in the value of both equity and debt. If stock prices rise, as they have since the equity market hit bottom in October 2002, such ratios as debt to equity and debt to total capital will naturally fall.

In fact, while the median market value of the top 100 issuers’ assets rose 16 percent during the past six months, and their volatility fell by about 11 percent, the amount of the issuers’ short-term liabilities fell only 5 percent during that period, while their long-term liabilities rose by 7 percent. Clearly, companies’ likelihood of default has not been reduced much by efforts to lighten their debt burden.

That fact becomes even clearer when trends are examined over three years for the top 95 issuers. (Data for 5 of the top 100 issuers did not extend back to the beginning of the three-year study period.) Without the tailwind of rising stock prices helping to boost asset values and reduce their volatility, the median issuer’s chances of defaulting within a year are up almost 30 percent during the past three years, says MKMV. The median issuer’s asset values rose less than 1 percent during that period, while its short-term liabilities rose slightly and its long-term obligations soared by almost half.

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