Now into our 18th year of working with treasury managers across the country, it’s as clear as ever that managing risk remains one of the least understood and most challenging areas of corporate cash management. The treasury landscape is littered with painful examples of write-downs from highly rated securities whose risk was miscalculated, misunderstood, or misrepresented. Corporate treasury functions can certainly improve their effectiveness in this environment through a better understanding of the pitfalls associated with managing credit risk.
With 17+ years of hindsight, we summarize the three most common credit-related deficiencies in today’s corporate cash portfolios: 1) overconfidence in credit ratings; 2) falling victim to non-traditional investments; and 3) insufficiency or misinterpretation of investment policies.
1. Overconfidence in Credit Ratings
Ratings assigned by Nationally Recognized Statistical Rating Organizations (NRSROs), such as Moody’s Investors Service and Standard & Poor’s, provide valuable information on an investment’s creditworthiness. However, ratings alone almost never adequately address the pertinent credit risks of a given investment.
First, ratings tend to be “sticky” since the rating process requires ratings to be “through the cycle”, meaning that ratings take into consideration a credit’s ability to weather a down business cycle marked by higher interest rates, reduced demand, and slower profit growth. Ratings change only when a NRSRO determines that a company’s credit deterioration is the result of a long-term trend, by which time bond prices may have already reflected that fact.
In addition, many large user groups of bond ratings appreciate rating stability over time. For example, credit ratings are widely used as credit measures of bank and insurance company capital adequacy, as well as in company debt covenants. Rapid rating changes may cause significant problems throughout the financial system. Rating agencies have proposed to have ratings reflect faster changes in business and market environments, but most user groups, including investors, have opposed such initiatives.
Finally, the credit rating agencies have recently faced harsh criticism resulting from the fact that they have not incorporated multiple forms of risk (liquidity or structure) into their ratings. For example, virtually all outstanding auction rate securities continue to maintain the highest credit ratings while the market remains almost entirely illiquid with very limited trading activity.
Remedy: Investors should only use ratings as a starting point in the credit screening process, and should periodically review current operating and market conditions that may affect a company’s business activities, financial leverage, cash flow behavior, and its ability to access the capital markets.
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