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While there may well be exceptions, generally it is expected that a com-
pany within a country is constrained in its credit rating potential by the
uppermost credit rating assigned to the country where it is located. For this
reason, it is rare to see a rating agency rate a company better than the over-
all rating assigned to the country in which it is domiciled. Thus, it some-
times is said that a country™s foreign currency rating serves as a ceiling with
respect to permissible ratings for companies within that country. That is, if
a country™s score were rated as AA , then the best a company within that
country could hope for in terms of a rating also would be AA . At the core
of this is the assumption that if a country fails at the sovereign level, then it
is failing (or the larger failure will precipitate a failing) in the private sector
as well. Yet a company within a country™s borders may well be rated better
than the country itself. Three scenarios for such an occurrence follow.

1. If the company is domiciled within the country but is a multinational
company with a well-diversified geographical distribution of other
related companies, and if the company™s locally raised debt is not some-
how confined to that one country alone (meaning that when the com-
pany issues debt within the country, it does so as a true multinational
company and not as a stand-alone entity within the country), then it may
well carry a credit rating superior to the country where it is located.
2. Strong company links to the outside world”links perhaps even stronger
than those of the government itself”may help with a superior rating
scenario. For example, if the company were an exporter of a particular
commodity generally in strong demand (i.e., oil), a stand-alone status
might be warranted.
3. The use of a creative financing arrangement might be sufficient to make
the difference with a given rating decision. For example, in the 1970s
the Argentine government issued special Bonex bonds, denominated in
U.S. dollars. A principal reason for their sale was to facilitate a return
of Argentine capital that had fled abroad. In addition to transferring
foreign exchange risk to the U.S. dollar from the Argentinean peso,
Bonex bonds were exempt from currency controls, were guaranteed by
the government, and were freely tradable in Argentina and abroad.
Bonex bonds were so successful that the so-called Bonex clause
appeared in many contractual arrangements with Argentina in the



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1970s and thereafter, stipulating that if access to dollars via traditional
channels were to become limited, then there would be the obligation
to obtain U.S. dollars via Bonex securities.

Just as a country™s local currency and foreign currency ratings can have
an important impact on national debt management policies (affecting such
things as its cost of debt), these ratings can have enormous implications for
the companies domiciled within the country. While there can be exceptions
to a company™s rating being capped by respective sovereign ratings, these
exceptions are rare.
Sometimes the perception of the credit risk of a particular geographic
region (or collection of countries) can have an impact (positive or negative)
on a country™s rating. For example, in the year immediately following per-
ceptions of credit weakness in Asia (Asia™s financial situation more or less
began deteriorating in late 1997), it was clear to most market observers that
Singapore was faring quite well relative to other regional countries. While
the rating agencies explicitly recognized this greater relative strength of
Singapore, because the region as a whole was still emerging from a very large
shock to the financial markets (or so went many rating agency explanations
at the time), Singapore continued to be rated below what it otherwise would
have been rated if the region as a whole had been considered more resilient.
This illustration highlights the fact that credit rating is performed on a
relative basis, not an absolute basis. As such, it can be predicted that there
will never be a time in the marketplace where there is (are) no triple-A rated
entity(s). A primary reason is that the perfect triple-A entity does not exist
and realities of the true marketplace are what set the stage for relative (not
absolute) strength and weakness in credit quality. After all, even the U.S.
Treasury saw a portion of its securities placed in credit watch in 1996, when
a budget impasse necessitated a federal government shutdown. Yet the U.S.
government maintained the triple-A rating that it has enjoyed for many
years and will likely continue to enjoy for years to come. Again, perhaps
what is of relevance is that there is no such thing as a perfect triple-A coun-
try or company. Further, it ought to be noted that given the dramatic dif-
ferences between a triple-A country like the United States, and any triple-A
rated company, an investor would be ill-served to lump all triple-A securi-
ties into one basket regardless of entity type. That is, not all triple-A enti-
ties are created equal, and the same may be said of other credit
classifications. In the case of the United States it is clearly a triple-A that is
first among unequals.
Figure 3.1 presents a currency-issuer-rating triangle. There are impor-
tant credit linkages among the three profiles shown. Clearly, a company must
be based somewhere. Hence, a company™s issuer rating is going to be influ-
enced by the currency in which it transacts its daily business, and the local



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Local
Issuer currency
rating rating

Foreign currency
rating


FIGURE 3.1 Currency rating triangle.


currency rating is thus a relevant consideration. However, this is not to say
that the local currency rating serves as a ceiling for what any issuer rating
might aspire to; a local government would have limited interest in restrict-
ing free access to its own currency. Yet the foreign currency rating, which
evaluates the local government™s stance on unfettered access to foreign cur-
rencies, can serve as ceiling to a local issuer™s rating. However, there are sev-
eral ways that an issuer™s financial instruments might secure a rating above
the relevant foreign currency rating. In almost every case where an issuer™s
rating rises above the local currency rating, the crucial factor is the issuer™s
being able to have access to some nonnational currency(s) in the event of a
country-level default scenario.
While these various risk considerations are not of any immediate con-
cern for G-7 and other well-developed markets, they can be quite important
for emerging market (nondeveloped markets like those of certain parts of
South America or Africa) securities, a segment of the global market that is
large and growing.
For more of a discussion on the important role of currency ratings and
their impact, see “Emerging Markets Instability: Do Sovereign Ratings
Affect Country Risk and Stock Returns?”, February 2001, by Graciela
Kaminsky of George Washington University and Sergio Smukler of the World
Bank. They find that the answer to the question posed in their title is “yes.”
As to specific case studies, consider the instance of Standard and Poor™s deci-
sion in September 2002 to lower India™s long-term soverign currency rating
from BBB to BB and to downgrade India™s short-term local currency rat-
ing to B from a previous A-3. Consistent with previous adverse announce-
ments by Standard and Poor™s about India (dating back to at least October
2000), currency, equity, and bond markets reacted negatively to the news.
A headline from the ENS Economic Bureau as provided by Indian Express
Newspapers on October 11, 2000, read “S&P Downgrade Hits Rupee [cur-
rency], Bonds.”




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Credit
Cash flows
Spot
Bonds




Earlier it was stated that rating agencies can assign credit ratings to com-
panies as well as to the financial products of companies. When a credit rat-
ing is assigned at the company level, unless something dramatic happens in
a positive or negative way, the rating typically sticks for a rather long time
(sometimes many years). A company can do very little on a day-to-day basis
to greatly influence its overall credit standing. Conversely, a company™s finan-
cial products can be structured on a very short-term basis so as to satisfy
rating agency criteria for receiving a rating that is higher than the overall
company rating. In some instances a company may even seek to issue prod-
ucts with a rating below the company rating.
Generally speaking, all of the ways that a company might influence its
financial product ratings are ultimately linked to cash flow considerations.
This section presents those cash flow considerations in two categories as they
relate to spot and bonds: collateralization and capital.


COLLATERALIZATION AND CAPITAL

Collateralization
Collateralization is one of the most basic and fundamental considerations
when evaluating the credit risk of a bond (or any security). When a bank
considers a loan to a homeowner or businessperson, one of the first things
it is interested in learning is what the potential debtor has of value to col-
lateralize against the loan. When it is a home loan, the home itself generally
serves as the collateral. That is, if the homeowner is unable to make pay-
ments and ultimately defaults on the loan, then the bank often takes pos-
session of the home and sells it. The proceeds from the sale go first to the
bank to cover its costs and then any remaining funds will go to the home-
owner. At the time a loan application is being reviewed, the bank also will
want to review a homeowner™s other assets (investments, retirement funds,
etc.) as well as annual compensation.




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With a business loan, the businessperson may have little capital in the
business itself. The person may be renting the office space, and there may
be little in the way of company assets aside from some office furniture and
computer equipment. In such a case, the bank may ask the businessperson
to provide some kind of nonbusiness collateralization, such as the deed to
a property (a home or perhaps some land that is owned). If the business is
profitable and simply in need of a short-term capital injection, the docu-
mented revenue streams may be sufficient to assure the bank of a business™s
creditworthiness. However, even if the business loan is granted and primar-
ily on the basis of anticipated revenue, it is very likely that the rate of inter-
est that is charged will be higher than what it could have been if collateral
had been provided.
The issue of collateral is key to understanding another dimension of the
difference between a bond and an equity. By virtue of a bondholder™s hav-
ing a more senior claim against the assets of an entity relative to a share-
holder in the event of the entity™s default, the bondholder is much closer to
the issuer™s collateral. Perhaps another way to put this would be as follows:
While both a bond- and shareholder obviously hope for the ongoing via-
bility and success of an issuer, a bondholder may be banking more on the
ongoing value of the issuer™s underlying assets while the shareholder is per-
haps banking more on the ongoing profitability of the issuer™s business.
Generally speaking, the uncertainty of the former is typically less than the
uncertainty of the latter. This fact may help to explain the greater price vari-
ability in mainstream equities versus mainstream bonds, as well as the greater
risk-return profiles of equities versus bonds.
As a last comment on the role of collateralization and credit, let us con-
sider overcollateralization.
As the term suggests, to overcollateralize a debt means to provide more
dollar value of assets relative to the debt itself. For example, if a business
loan is for $50,000 and $75,000 of assets is provided to collateralize it (per-
haps the businessperson owns the office space), then the loan is overcollat-
eralized. All else being equal, the businessperson should expect to pay a lower
rate of interest relative to an uncollateralized loan.
Sometimes banks bundle together various loan profiles they have
amassed and then securitize them. To securitize a bundle of loans simply
means that the loans have been packaged into a single security to be sold to
investors, generally in the form of a coupon-bearing bond. The coupons are
paid out of the monthly interest payments provided by the various debtors,
and the principal comes from the principal payments of the same loans. A
bank might choose to securitize its loans to turn its liabilities into assets.
When a bank has an outstanding loan, it is a liability; the person with the
bank™s money may or may not make good on the obligation. By bundling
loans together and selling them as bonds, banks turn these liabilities into



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immediate cash. Banks can use this new cash to turn around and make more
loans if they so choose, and repeat the process over and over again. There
is a risk transfer whereby the risk of the loans being paid is shifted away
from the banks and into the hands of the investors who purchase the bonds.
Banks make a variety of different types of loans, including home loans,
auto loans, boat loans, and so forth. When these loans are securitized as
bonds (and typically by respective categories of home, auto, etc.), they are
sometimes referred to as asset-backed securities, because the loans are
backed-by (collateralized by) the property underlying the loan (the home,
the car, whatever). Typically a designated servicer of the asset-backed secu-
rities actually goes through the machinations of repossessing and selling
assets when required.
Investors like to know the rating on the asset-backed securities they are
being asked to purchase, just as they like to know the rating of any credit-
sensitive securities they have been asked to buy. Going through the paper-
work of the literally hundreds of persons whose individual loans might
comprise a given asset-backed bond, all for the purpose of coming up with
some aggregate credit risk profile, would be a rather daunting task (not to
mention the legal considerations likely involved). A proposed solution for
this, and one readily accepted by investors, is to overcollateralize the bond.
By placing a face amount of loans into an asset-backed deal that is in excess

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