0:16

It shows the importance of credit ratings.

It's a fundamental variable for credit markets, and what we see in this

picture is that every country in the world actually has a credit rating.

Countries borrow in debt markets, and what happens is that rating agencies have to

determine what is the likelihood that a country will default on its debts?

So, you can see that most countries, actually, not everywhere.

There are some places in Africa that don't have a credit rating, and Asia.

But by and large, you can see that every country has a credit rating.

So, this is just an interesting way to think about the world, right?

These are the credit ratings that we're talking about.

It goes from AAA, which is the highest rating.

If you're looking at S&P, there are other companies that do credit ratings as well.

So, ratings go from AAA, all the way down to default.

So, if a company's rated D, down here, it means that you defaulted.

If you have a high rating,

it means that you have a low probability of default, okay?

And rating agencies like to separate these ratings into two categories.

2:27

It probably would not be a great business model to have a mathematical

model that use a very precise answer, right?

And then what people could do is just replicate that model,

and it would send the rating agencies out of business.

So, the bottom line is that it's a measure of the chance that they issue a default,

but it's not the purely objective measure.

3:07

So, rating agencies are a combination of objective data and subjective calls.

What we can do is we can try to look at the objective side.

Which variables matter most for ratings?

Let's bring our researcher here.

People have done research on this, right?

It's fairly straightforward.

We have the ratings from standard imports, right?

And then we have the data on the companies.

We can try to relate them and see which variables are related to ratings.

So, I'm going to show you two tables.

This table actually comes from a paper that I wrote recently about

credit ratings.

It's a regression, if you learned about regression,

maybe in your statistics course,

it's a regression of credit rating on different firm characteristics.

The variables that I have here in this regression,

we actually talked about already in this course.

So, ROA is a measure of profitability, is the company's profit divided by assets.

Size, is obvious, and then leverage, right,

which is what we were talking about in module one.

What you'll see in this regression table is that

profits are positively correlated with ratings.

So, profitable companies have higher ratings.

Larger companies have higher ratings, and companies that have higher leverage.

If you have a lot of debt, you're going to end up with a lower credit rating.

The regression also has square terms, but

it really doesn't really change the degradation that much.

And here's an interesting observation.

The R square of a regression, again, if you cover this in your statistics course,

which It's a very important tool for finance.

The R square shows that it's a 0.6 R square, 0.587, approximating to 0.6.

This shows that these variables, profit size and leverage explain

a lot of the variation in credit ratings, but they don't explain 100%.

So, there's 40% of the variation in credit ratings that perhaps

are capturing the subjective judgment that

the rating agencies exercise when they give out credit ratings.

5:22

Another way to look at credit ratings is to look at leverage ratios per rating.

So here, we have the highest rating, AAA, when we look at the leverage ration that I

wrote down explicitly here as total debt divided by the market value of assets,

you see that it will only be 3.7% for AAA rated companies.

And the leverage ratio keeps increasing as the ratings go down, right?

So, there is a one-to-one relationship between ratings and leverage ratio.

We can also look at EBIT interest coverage,

which is another financial ratio we talk about in corporate finance one.

It's the ratio of EBIT operating income to interest payments.

It's essentially telling us how large are the company's profits

relative to the interest payment.

And again, you see that there's this one to one relationship between how much

the company borrow, and the credit rating that is given by the rating agency.

6:21

To summarize, essentially what we've seen is

that highly levered companies are going to have lower credit ratings, right?

Particularly so if they are small and less profitable.

There is this one-to-one relationship between rating and

leverage, which makes sense, but this raises an interesting question.

Why should we care about ratings then?

Maybe then off to just think about leverage, right?

In Module 1 of corporate finance two, will already talked about how to determine and

optimal leverage ration, which consideration is going through that?

Why do we care about ratings?

6:54

Let's bring back our researcher.

There's been a lot of research about credit ratings and

corporate finance recently, including a paper that I wrote I'm going to show you.

But, here is the answer.

Here's why companies should care about a credit rating.

The idea is that a rating downgrade

can have a very significant impact on the cost of capital for a company.

This is what Kisgen showed in his research.

There are several papers that Darren Kisgen wrote about this issue.

And some of the reasons why a rating downgrade matters, because

rating downgrade affects variables, like access to commercial paper mark.

We're going to talk about commercial paper later on in this module.

Companies with low rating cannot tax as credit rating.

8:02

Bank capital requirements are also tied to ratings.

If banks make a loan that has a low rating, the bank has to hold

more capital against that loan, increasing the cost of the loan for the bank.

And finally, ratings can trigger violations of financial covenant,

which is that it's another issue that we're going to talk about in this module.

If you don't know what a financial covenant is, you're going to learn soon.

So, here's the summary that I was talking about.

So, access to commercial paper, insurance companies can be restricted

from investing in junk bonds, so on and so forth.

The bottom line is that there are lots of frictions in financial

markets that are related to credit ratings.

8:44

A rating downgrade can really matter for a company.

Recently, I've followed up on this idea with my

to think about sovereign downgrade.

What happens in a sovereign downgrade is that some companies tend to be downgraded

together with the country.

For example, we have this example of EDP Energias, which is a Portuguese company.

It got downgraded from A to BBB- together with Portugal in March, 2011.

So, Portugal got downgraded from A to BBB-,

EDP Energias got downgraded together with Portugal, that happens because

the rating agencies use something that is called the ceiling room.

They don't like rating a Portuguese company higher than the country, so

what tends to happen in the data we've shown is that companies like EDP Energias,

they tend to get downgrade together with the sovereign.

Okay, and what we show in our paper is that the sovereign downgrades cause

a significant increase in the cost of capital for companies like EDP Energias.

This is a study that look at many countries, many years.

And it's summarized here in this picture, essentially,

this blue line shows what happens to companies that get downgraded.

You can see that the y-axis is measuring the spread.

So, these companies usually have a lower spread than the other companies in

the economy, because they are the companies with high ratings, right?

EDP Energies had the same rating as Portugal.

Those tend to be the highly rated companies in the country.

But following the downgrade, the sovereign downgrade is marked here by this line,

the cost of capital increased a lot for companies like EDP Energies.

10:32

Bond spreads increased significantly.

We'll show in our paper that this has severe consequences for

what happens with these companies.

Okay, what this means is that, there is a very important idea in corporate finest.

Managers should care about credit rating.

Capital structure is not just about determining

an optimal amount of leverage you have, a company should also be thinking about

how the rating agency going to react to my financial decision, okay?

This is a very nice quote that I took from GE's annual reporting in 2006.

It shows exactly this idea.

It's one of the strategic objectives of GE when they think about financial policy

to maintain their credit rating.

At that time, was AAA, right?

The reason is that it lowers cost of funds, facilitate access to a variety of

lenders, and etc, which is exactly what we've been talking about.

So, credit ratings do matter and companies should target credit ratings.

Actually has this very nice idea that I'm showing you here.

It actually changes the way you think about the trade off model.

Remember that we had that picture that related value to a leverage, right?

So, when leverage goes up, value goes up, and then it goes down, right?

That allows you to think about the optimal capital structure.

11:56

Credit ratings make this picture jagged, like what I have here, right?

So for example, there are these points when,

if you increase leverage beyond that point, you might get a downgrade.

If a company gets downgraded, there's going to be

a significant change in form value, because of increasing the cost of capital.

So, your value you can see in that picture,

the value is dropping by a discrete amount.

When you change, your leverage by a little bit, so

this picture becomes jagged is one way to think about how ratings really matter when

a financial manager determines optimal [INAUDIBLE].