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The basic methodology to be employed in rating a bond or sukuk follows the same approach as the Methodology for Corporate Rating. This methodology should therefore be read in conjunction with that methodology and/or the methodologies covering specialised sectors where applicable.
Bond Ratings and Issuer Ratings
Where no special factors apply, it is to be expected that the rating for a senior unsecured bond issued by a company will be the same as the corporate rating of the same issuer. However the following special factors may make a different rating appropriate.
- The bond is secured
- The bond is guaranteed
- The bond is formally subordinated
- Effective subordination of the bond due to security granted to other lenders
- Structural subordination
The Bond is Secured - The effect of security will depend on its form, value and legal position. Security in the form of cash is always given the highest value. However other forms of security such as equities or other investments and mortgages on real estate are also acceptable (depending on market) although the value should be discounted to some extent to reflect liquidity and market risk.
CI therefore looks at the liquidity of equities or other investments that form part of a security package, and form a view also as to the risk inherent in a market correction. When the security is in the form of real estate, how readily the property could be sold (and how close to its appraised price) is a major consideration. CI will typically obtain at least one independent external valuation that is no older than 12 months prior to the date of the rating.
Once the value of the security package elements has been ascertained, we consider whether the coverage ratio is sufficient to prompt an upward move in the rating; normally a comfortable over-collateralisation ratio will be required to mitigate market and liquidity risks. If the ratio is too low, the available security may not be sufficient to justify a higher rating. A secured bond (or a sukuk) will normally carry a rating one notch higher than the equivalent senior unsecured rating. However should the issue benefit from an exceptionally strong security package, more than one notch may be considered. Equally there may be cases where the security package is not considered strong enough to raise the rating even though its presence does improve the quality of the credit.
The legal position of a security package is an important consideration. We will seek to establish (usually via the manager or agent for the issue) that the legal interests of the bondholders are properly safeguarded and in particular that neither the issuer nor other creditors can legally lay claim to the assets in the security package.
The Bond is Guaranteed - Where there is a formal and legal guarantee by a parent or a third party, the rating of the bond will normally be the higher of the issuer or the guarantor. However care is taken in situations where either the guarantor is financially weak or where to perform under the guarantee would put the guarantor in breach of his own borrowing covenants.
The Bond is Formally Subordinated - Such a bond will normally be rated at least one notch below the senior unsecured rating of the same issue. However the terms of the bond and its seniority in the ladder of obligations of the issuer must be carefully examined; there may be situations where more than one notch below is appropriate. This would normally only occur where there is more than one form of subordinated issue or obligation in existence.
Effective Subordination Due to Security Granted on Other Borrowings - CI takes care to ensure that the potential issuer has not already provided security to other lenders (usually banks). If such security has been granted, the effect will depend on the amount of the security, to whom it has been given and the underlying nature of the transaction concerned.
The simplest case is where a potential issuer has provided collateral for most or all of his bank borrowings. In such a case, the holders of an unsecured bond issue would be effectively in a subordinate position to bank lenders. In this case we would probably reduce the rating that would otherwise have been given by one notch.
Other cases may be less clear cut. There are situations where the amount of secured debt is small in relation to the total or where an investment portfolio has been pledged as part of a leverage arrangement to increase the size of that portfolio. In such cases it may not be appropriate to notch the rating downwards. CI therefore carefully considers the extent of the effective subordination in relation to overall borrowings, to shareholders funds and to the asset base of the company.
Special care is also taken with the use of sale and leaseback of assets. If a company does this, it is effectively reducing the asset base that would be available to creditors (including the bondholders) in case of liquidation - the effect can once again be equivalent to effective subordination.
CI would check the position at the time that the potential issue is first rated and continue to do so on a regular basis thereafter by a careful analysis of quarterly financial statements. Should these show any significant increase is secured borrowing, we would consider reviewing the rating.
Structural Subordination - This occurs when the structure of a group is such that the potential issuer faces obstacles or potential prior claims on its cash flows. This would normally be a factor to consider where the potential issuer is a holding company rather than an operating company (albeit that it may also have some operations in its own right). Factors to consider include the borrowings or bond issues of the operating subsidiaries and, in particular, any covenants restricting payments of dividends or other transfers of cash to its parent.
Covenants - Most bond issues will include covenants. Some are standard. Others are not. We normally seek to examine the proposed issue documentation to ensure that the standard covenants are in place. The most important of these is a negative pledge on granting security to other lenders in the future (and not just to other bond issues). If such a clause is absent, this reinforces the need to regularly check the amount of any secured borrowing by the issuer.
Other covenants may be offered by the potential issuer to strengthen what would otherwise be perhaps a borderline case. While such covenants (examples would be on leverage, liquidity and minimum net worth) can add value they are unlikely in of themselves to be sufficient to raise a rating in most cases. Moreover such covenants can be a double-edged sword as their breach would be at least a technical event of default. If such a default were then to trigger cross-default clauses in other credit agreements, what was a relatively minor problem could become a financial crisis that threatens the interests of bondholders.