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.

The upshot: if stock prices don’t maintain their recent momentum—a distinct possibility in light of persistently weak economic conditions—many if not most debt-laden companies could soon be back where they started not long after the market bubble burst, with investors seriously worried about their balance sheets.

Analyzing Default Risk

The MKMV study uses a proprietary methodology to analyze a company’s likelihood of defaulting, which it expresses as its trademarked Moody’s KMV Expected Default Frequency (EDF). The firm counts some 80 of the world’s 100 largest banks as its clients, and almost all of them use the methodology to make decisions on loans and to manage risk, says MKMV president Doug Woodham. (See “Explaining EDF,” at the end of this article, for a detailed explanation of MKMV’s methodology.)

Because trends in supply and trading volumes can influence spreads on bonds and credit derivatives, and because ratings change so slowly, MKMV’s methodology is a more accurate measure of short-term changes in credit quality, claims Woodham. It has “higher accuracy in terms of predicting default,” he says, and therefore serves banks well as “an early warning system.” (One reason for that may be that the methodology takes into account any off-balance-sheet debt, as efforts to move assets and liabilities off the balance sheet reduce the value of what remains.)

What’s more, says Woodham, a number of banks are using the methodology to help determine whether they’re earning enough on corporate credit, and using that to figure out how much more fee income they may need from providing other services to a company to make the relationship worthwhile. The methodology is also being used by an increasing number of institutional investors, he adds. Given that, MKMV’s most recent findings suggest that the cost of capital supplied by banks and the public debt markets for many large issuers of debt may be higher than credit ratings alone may lead their finance executives to expect.

The study does confirm the impression that corporate credit quality is improving—though, again, the main reason is rising stock prices, not falling debt. MKMV found that the likelihood that companies will default on their debt obligations within a year or so has fallen dramatically during the past 12 months, and especially the past 6 (see “Trend Spotting” at the end of this article).

Lightening the Load

Issuing public debt, however, is only one of the circumstances that make private companies subject to Sarbox. Those attempting to merge with public companies, of course, must prepare to comply. And, increasingly, lenders and investment bankers are using the act’s provisions as a due-diligence gold standard.

Of course, the study also shows wide variations in the data among individual companies (see “Explaining EDF” at the end of this article). And that reflects different approaches to balance- sheet management, as interviews with top finance executives at some of these firms illustrate.

Companies like Nextel, Verizon Communications Inc., and Xerox Corp., for instance, have done much to reduce their short- or long-term liabilities, or both. To one degree or another, they’ve cut spending and shed noncore assets, using the cash to pay down debt, exchange it for equity, or both. Where possible, they’ve also refinanced debt—terming out short-term obligations, or substituting cheaper short-term debt for long-term—to improve their interest coverage. But that’s easier said than done, which helps explain why other companies still labor under heavier obligations than they might want.


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