Article 6.2 Moody's cuts Sony rating to junk

By Jennifer Thompson

Financial Times January 27, 2014

Moody's Investors Service has cut the credit rating of Sony to junk status saying that the Japanese group's profitability is likely to remain ‘weak and volatile' until the turnround of its television and personal computer businesses translates into better earnings.

The credit rating agency on Monday downgraded Sony to Ba1, one level below investment grade, from Baa3. Moody's said the majority of the group's consumer electronics businesses, such as televisions, digital cameras and personal com­puters, faced loss of technology leadership and increasing competition.

Fitch Ratings downgraded the credit rating of Sony to junk in 2012. Standard & Poor's rates Sony's credit at BBB, or two notches above junk.

Like other Japanese electronics companies Sony is battling rivals Apple in the US and South Korea's Samsung, particularly in smartphone sales.

But unlike its peers Sharp and Panasonic, which lean more towards household electronics, Sony faces a second dilemma: its focus on entertainment devices, such as radios, digital cameras and televisions, mean that the success of one of its divisions often comes at the expense of the other as smartphones become more sophisticated.

‘The primary reason [for the downgrade] is intense competition and the shrinkage in demand, the result in turn of cannibalisation caused by the rapid penetration of smartphones,' Moody's said in a statement.

FT

Source: Thompson. J. (2014) Moody's cuts Sony rating to junk, Financial Times, 27 January.

Box 6.1

The junk bond wizard: Michael Milken

While studying at Wharton Business School in the 1970s Michael Milken came to the belief that the gap in interest rates between safe bonds and high-yield bonds was excessive, given the relative risks. This created an opportunity for financial institutions to make an acceptable return from junk bonds, given their risk level.

At the investment banking firm Drexel Burnham Lambert, Milken was able to persuade a large body of institutional investors to supply finance to the junk bond market as well as provide a service to corporations wishing to grow through the use of junk bonds. Small firms were able to raise billions of dollars to take over large US corporations. Many of these issuers of junk bonds had debt ratios of 90% and above - for every $1 of share capital, $9 was borrowed. These gearing levels con­cerned many in the financial markets. It was thought that companies were pushing their luck too far and indeed many did collapse under the weight of their debt.

The market was dealt a particularly severe blow when Michael Milken was convicted, sent to jail and ordered to pay $600 million in fines. Drexel was also convicted, paid $650 million in fines and filed for bankruptcy in 1990.

The junk bond market was in a sorry state in the early 1990s, with high levels of default and few new issues. However, it did not take long for the market to recover.

Issuers of high-yield bonds

High-yield bond finance is sometimes used when bank or senior bond borrow­ing limits are reached and the firm cannot or will not issue more equity. Junk bonds provide cheaper finance (in terms of required return) to the company than would be available on the equity market and they allow the owners of a business to raise large sums of money without sacrificing control because bonds do not carry votes, whereas new equity usually assigns votes over key company matters, so selling shares to outsiders would mean lower percentage control over the company for existing shareholders.

Senior lenders to a firm (e.g. banks and bond holders) usually impose limits on the senior debt to equity ratio. However, subordinated debt might be accept­able to senior bond holders and equity holders alike. Thus, junk bonds are a form of finance that permits the firm to move beyond what is normally consid­ered an acceptable debt:equity ratio (financial gearing, leverage levels).

High-yield bonds have been employed by firms ‘gearing themselves up' to finance merger activity by raising cash to pay for the target's shares. They are also useful for leveraged recapitalisations. For instance, a firm might have run into trouble, defaulted and its assets are now under the control of a group of creditors, including bankers and bond holders. One way to allow the business to continue would be to persuade the creditors to accept alternative financial securities in place of their debt securities to bring the leverage to a reasonable level. They might be prepared to accept a mixture of shares and high-yield bonds. The bonds permit the holders to receive high interest rates in recognition of the riskiness of the firm, and they open up the possibility of an exceptionally high return from warrants or share options should the firm get back to a growth path. The alternative for the lenders may be a return of only a few pence in the pound from the immediate liquidation of the firm's assets.

Junk bond borrowing usually leads to high debt levels, resulting in a high fixed-cost imposition on the firm. This can be a dangerous way of financing expansion and therefore the use of these types of finance has been criticised. Yet some commentators have praised the way in which high gearing and large annual interest payments have focused the minds of managers and engen­dered extraordinary performance. Also, without this finance, many takeovers, buyouts and financial restructurings could not take place.

Market price movements

Investment-grade bond prices and returns tend to move in line with govern­ment bond interest rates, influenced mainly by perceptions of future inflation rather than the risk of default. Junk bond prices (and their yields), meanwhile, are much more related to the prospects for the company's trading fundamen­tals because the company needs to thrive if it is to cope with the high debt and raised interest levels, and to cause the equity kicker to have some value.

As a result high-yield bonds are, in general, far more volatile than investment­grade bonds, going up and down depending on expectations concerning the company's survival, strength and profitability. In 2009, for example, investors were very risk averse, requiring yields of more than 20% for a typical euro high-yield bond; in 2014 they lent ‘high-yield' for less than a 5% return per year, perceiving company business risk to be relatively low, lured by low recent default rates and factoring in low inflation expectations.

Comparing US and European high-yield bond markets

Historically, high-yield bonds have been much more popular in the US than in Europe, but as the recovery from the financial crises takes hold, high-yield bonds have grown in popularity in Europe (see Article 6.3) and now the annual amounts raised are about the same, both more than ˆ100 billion or $130 billion. For Europe this is rapid growth for a market that started only in 1997 when the first high-yield bond denominated in a European currency was issued: Geberit, a Swiss/UK manufacturer, raised DM157.5 million by selling ten-year bonds offering an interest rate 423 basis points higher than on a ten- year German government bond.