What Can Corporate Treasurers Do to Mitigate Sovereign Risk?
In Fitch’s most recent review of corporate treasury policies in Europe, Middle East and Africa (EMEA) and Asia-Pacific regions, we found that macroeconomic and banking system uncertainties are keeping liquidity concerns and the risks to liquid assets at the top of treasurers’ agendas. Of the 181 issuers we surveyed, preservation of liquid assets was a shared concern globally with 77% targeting ratings of A- and above for their holdings.
Delving into this figure a little deeper, 85% of developed market issuers targeted this rating level in 2011 compared with 78% back in 2008. The shift to higher-rated investments was even more striking for emerging issuers, with 56% of them targeting A- as the minimum rating compared with only 19% in 2008. We also found that half of the issuers reviewed their treasury policies for liquid assets holdings, with a notable reduction in the exposure to money market funds (MMFs), where only 32% of issuers invested in this asset class in 2011 compared with almost 40% in 2010.
Treasurers have also continued to actively scrutinise whom they trust to hold their liquid assets, with 37% indicating that they changed their relationship banks. While this represents a drop from 2010 (64%), it provides further evidence that rationalisation was already well underway last year. The survey also showed that the reliance on domestic bank funding for corporates was highest in France and peripheral Europe, compared with peers in other countries.
However, overall, funding disintermediation from the bank loan to corporate bond market continues, with 85% of respondents stating that they had increased their debt mix to capital markets. In particular, emerging market corporates confirmed their shift, with 67% of them reporting a change in their debt structure away from bank debt.
Committed Facilities and Sovereign Stress
Fitch is regularly asked by investors whether we think a heightened period of sovereign stress could cause banks to back out of committed facilities for corporates. Our answer is a qualified “no”. We currently think a ‘failed draw’ for investment grade issuers is highly unlikely, and the kind of step that a major commercial bank would only take when it is under extreme duress. The level of diversification by treasurers in their relationship banks also makes this a low likelihood event for an investment grade issuer and something we would only consider as an outlying scenario under a ‘shock case’.
We note that some investment grade corporate issuers have nonetheless increasingly been testing their banking groups with periodic draws in excess of actual working capital needs. A failed draw for a speculative grade issuer, however, while still unlikely, would be far from unprecedented, particularly from a bank in a lending syndicate nominally committed to lend to an issuer that was either enveloped in a ‘story credit environment’, or where covenant compliance was questioned.
By ‘story credit environment’, Fitch has traditionally meant issuers who have been: rapidly downgraded, or faced with imminent or ongoing covenant negotiations; subject to high-profile concerns over management or governance issues, and/or in a sector which has attracted one or both of the preceding factors.
Corporate Liquidity in the Periphery and Sovereign Linkages
Fitch updated its issuer level liquidity forecasts for corporates in the periphery in May 2012, finding that the vast majority have sufficient liquidity, including our expectations for free cash flow, to last until 2014. However, while they may be insulated from the current economic turbulence, they are certainly not immune. Furthermore, sovereign ratings in the region, which have fallen, and remain on negative outlooks in most cases, are starting to exercise more material negative pressure on the ratings of corporates in their jurisdictions.
Approximately 60% of Fitch‘s peripheral corporate portfolio is on rating watch negative or negative outlook, dominated by utilities in Italy and Spain. By volume, the greatest driver of current negative outlooks/watches is the recent and contemplated changes to the remuneration framework in the Spanish utility sector. These affect not just Spanish utilities, but also utilities in Italy and Portugal which have invested in Spain. While not directly related to sovereign debt dynamics, this stress has been exacerbated by the financial challenges facing the Spanish economy.
Overall, we found that a further gross domestic product (GDP) fall-off would hit domestic issuers with the greatest exposure to the peripheral eurozone, such as Ireland’s the Electricity Supply Board (ESB), Italian power utility Enel and Telecom Italia. A Greek exit from the euro could trigger corporate rating downgrades further afield, dependent on the level of rating actions taken on the region‘s other sovereigns. In most cases, however, sovereigns would have to experience multi-notch downgrades before corporate ratings were affected, directly, by linkage to their sovereign.
Are Corporates Better Prepared than in 2008/9?
Fitch recently put its EMEA corporate rating portfolio through a ‘shock case’ stress test that was pitched between our existing ratings ‘base case’ of anaemic growth and a eurozone break-up scenario. The shock case was similar to 2008/09 in depth (eurozone GDP 2009: -4.5% versus shock case 2012: -3.5% and 2013: -1%) but the shock case recovery was much more protracted. An additional 300 basis points (bps) was also placed on the cost of new debt (compared with 2008 levels) and it was assumed working capital savings would not take place. Other assumptions included a bifurcated oil price (US$60/bbl in 2012 for producers, but stressing consumers with US$100/bbl).
Various commodities prices were also reduced, as was capital expenditure (capex) spend in some sectors. Our utility group also assumed that governments would impose a tariff freeze/price cap on utility bills to ease austerity-inflicted electorates’ hardship. This was on the basis that signs of such action by governments in this sector have already emerged in Italy, Spain and Portugal. Our autos group also assumed no repeat of the cash-for-clunkers sale initiatives launched in the early days of the financial crisis.
Based on these shock case assumptions, the higher rated oil and gas companies were downgraded by three notches and the utilities by at least two. Other adversely affected sectors included capital goods (up to two notches). The auto, chemical, heavy building materials, metals and telecoms sectors likely saw an average one notch downgrade. In contrast, high and low-rated alcoholic beverage companies were unlikely to be downgraded. The scale of the shock case downgrades were greater than the historical experience of 2008/09 overall, with a worse outcome for defensive sectors (utilities, telecoms, oil) and a better outcome for cyclical sectors (autos, building materials, capital goods).
This work underscored Fitch’s belief that some industries are now better placed to withstand this economic downturn compared to 2008/9, and most have reasonable levels of resilience to sovereign stress. For example, this time the steel and chemical industries have idled spare capacity, they have less stock overhang and rated companies have a better diversified product and geographical mix. Similar arguments apply to the auto manufacturers, although its overcapacity remains largely unaddressed.