The need for credit ratings in Malta

Financial Article 509 by Edward Rizzo - Oct 26, 2017

A credit rating agency is a private company whose objective is to assess the ability of borrowers, either governments or private companies, to repay their debt on time. As such, credit ratings are opinions given by agencies about an issuer’s credit risk.

The three largest rating agencies that are given ample coverage across the international media are Standard & Poor’s, Moody’s and Fitch Ratings. Each rating agency applies its own methodology in measuring creditworthiness and uses a specific rating scale to publish its rating opinions. Typically, credit ratings are expressed by letters corresponding to the potential risk. The highest rating (lowest risk) is represented by ‘AAA’ and the lowest rating (highest risk) is given a ‘C’ or ‘D’ depending on the agency. In addition to the letter grading, a credit rating also includes a forecast or outlook assessment on how a particular rating may change in the future. These are either ‘positive’, ‘stable’ or ‘negative’ and they indicate whether the agency in question may soon raise an issuer’s rating, downgrade it or leave it unchanged.

Credit rating agencies are remunerated via a fee charged to those issuers (a company or a government) seeking to receive a rating and also via a subscription fee on those (typically financial analysts or banks) wanting to have access to the rating reports.

While many investors (especially institutional investors) use credit ratings when contemplating investment decisions, the ratings are not measures of investment merit such as the typical ‘buy’, ‘hold’ or ‘sell’ recommendations normally issued by investment banks or other research houses. Credit ratings are also not intended to signal the suitability of an investment to a particular investor.

The only purpose of a credit rating is to assess the credit quality of an issuer, i.e. the probability of an issuer honouring or conversely defaulting on its obligations. As I have stated in many of my articles in the past, when evaluating an investment, investors should consider many other factors apart from the credit quality of the issuer, such as the current composition of one’s portfolio and exposure to different asset classes and group of companies, the investment strategy and time horizon as well as the risk tolerance.

Nonetheless, it is widely acknowledged that credit rating agencies play a central role across global financial markets. Normally, a top quality rating means a lower interest rate as opposed to a weak rating which translates into a higher interest rate for a borrower in order to compensate for the additional credit risk and to persuade investors to purchase the bonds.

Many investors must by now be accustomed to the terms ‘investment grade’ and ‘non-investment grade’ used very often in the media. Credit ratings between ‘AAA’ and ‘BBB-‘ are normally given to issuers with high levels of creditworthiness and securities issued by such companies or governments are normally referred to as ‘investment grade’. On the other hand, credit ratings lower than ‘BBB-‘, i.e. from ‘BB+’ to ‘D’, are classified as ‘non-investment grade’ or ‘speculative’ since such issuers are deemed to be facing significant uncertainties such as adverse business or financial circumstances that could affect credit risk.

‘AAA’ is the highest possible rating assigned to an issuer’s bonds by credit rating agencies implying that such issuers have an exceptional level of creditworthiness and therefore they can easily meet their financial commitments. There are currently 11 ‘AAA’ rated countries namely Australia, Canada, Denmark, Liechtenstein, Norway, Singapore, Sweden, Switzerland. Germany, Luxembourg and the Netherlands.

Standard & Poor’s downgraded the United States in August 2011 from ‘AAA’ to its second-highest rating ‘AA+’ due to rising debt levels, continued budget deficits and sharply deteriorating debt to GDP ratio.

The number of ‘AAA’ rated companies declined in recent years especially following the global financial crisis of 2008. In fact, even world-renowned companies, such as Berkshire Hathaway, General Electric and Pfizer have all lost their coveted ‘AAA’ rating after the 2008 financial crisis. More recently, in 2016, after almost 70 years, Exxon Mobil was also downgraded leaving only Johnson & Johnson and Microsoft in this elite category.

In October 2016, Standard & Poor’s upgraded Malta’s credit rating to ‘A-‘ while on 29 September 2017, the same agency maintained the ‘A-‘ rating but improved Malta’s outlook to positive from stable. Standard & Poor’s explained that Malta’s credit rating “may be increased over the next 24 months if economic growth remains in line with our expectations and is not derailed by factors such as external risks, and if budgetary consolidation and the reform of state-owned enterprises continues”.

If one were to look at the various companies that have their equities or bonds listed on the Main Market of the Malta Stock Exchange, unfortunately only two issuers currently engage international credit rating agencies to provide an assessment of their credit worthiness. Bank of Valletta plc has been regularly rated for several years. In the most recent update, Fitch Ratings downgraded BOV’s rating in November 2016 to ‘BBB’ with a stable outlook. The rating agency stated that “the downgrade of BOV reflects our view that its capitalisation is under pressure from increasing regulatory requirements and that its current capital ratios are not fully reflecting operational and market risks”. The rating agency had also acknowledged that BOV was considering strengthening its capital through a new share offer, but opined that this fund raising would not be sufficient to meet all future requirements and for the bank to maintain its current viability rating. Since BOV has publicly confirmed that it will be imminently conducting a €150 million rights issue, it will be interesting to understand the feedback from the rating agency once the fund raising exercise is concluded.

FIMBank’s current rating by Fitch Ratings is ‘BB’ with a stable outlook. In its most recent assessment concluded a short while ago, the agency explained that although FIMBank is working through legacy problem loans and restructuring under-performing factoring subsidiaries, any material improvement to the weak asset quality metrics will take time. Fitch also noted that FIMBank’s risk management and controls are improving but its capital is under pressure from poor internal capital generation and regulatory adjustments.

All other corporate bond issuers in Malta are not rated and in many instances, certain investors and financial analysts refer to Maltese corporate bonds as being ‘unrated’. While this may be factually correct, some investors also assume that these ‘unrated’ bonds are of a high risk and these companies will not manage to obtain an investment grade rating should an international rating agency apply the same methodology as that used across global financial markets.

Is this correct and are issuers being placed at a disadvantage for not obtaining a rating? For example, it is a well-known fact that certain institutional investors have limited appetite for ‘unrated’ bonds in part due to regulatory restrictions.

The credit metrics of many local companies have improved significantly in recent years and in some of my articles I have been giving coverage to two important credit metrics, the net debt to EBITDA multiple and the interest coverage ratio. From an analysis of the bond issuers on the Main Market of the Malta Stock Exchange, the most highly rated company is undoubtedly Simonds Farsons Cisk plc with an interest cover of over 14 times and a net debt to EBITDA multiple of just 1.7 times. The latter ratio implies that the overall net debt of the company can be repaid in under 2 years assuming the current level of profitability is maintained. This is a very strong ratio indeed even by international standards. In view of this, is it correct that analysts and institutional investors continue to refer to the bonds of Farsons as ‘unrated’ and therefore implying that they are below investment grade?

Another company that is probably not being given due recognition of its strong credit metrics is Premier Capital plc. The company boasts an interest cover of 7.4 times and a net debt to EBITDA multiple of 1.8 times.

As such, due to the lack of credit rating agencies, how are Maltese investors carrying out decisions on which issuers to take an exposure to? Is it simply seeking the highest returns or being blinded by some often misconceived wording such as ‘secured’ or ‘guaranteed’ without making due consideration to the credit metrics which are the more important factors to consider?

Since Maltese companies do not obtain credit ratings, are all companies really not in a position to be rated and are therefore deemed as being excessively risky? It is very often that we hear of many retail investors buying non-investment grade international bonds. Are these safer than the Maltese ‘unrated’ bonds?

These are some of the many questions that investors ought to ask themselves when comparing some local ‘unrated’ investment propositions to those found overseas. It may also be opportune for some Maltese companies to consider obtaining a credit rating when seeking to raise debt via the bond market. While the costs of the three largest agencies may be deemed to be prohibitive for some companies, some of the smaller and less-renowned agencies may be more competitive in this respect. The level of sophistication of Malta’s capital markets needs to improve and the use of credit rating agencies could be one of the initiatives required in this respect.

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