Article 5.3 Rio Tinto's Sam Walsh questions credit rating groups' relevance
By James Wilson and Neil Hume
Financial Times December 11, 2013
Rio Tinto's chief executive has signalled that he is not afraid of a downgrade by credit rating agencies, saying that he will not run the company according to their demands, in spite of possible consequences for borrowing costs at the indebted miner.
Sam Walsh said that agencies including Standard & Poor's and Moody's were using yardsticks that were of limited relevance to the miner and its shareholders.
His comments came as Rio told investors that it would make a priority next year of paying down debt, which has soared after misguided acquisitions and heavy investment.
Mr Walsh acknowledged that he no longer saw Rio's single-A rating, given by Standard & Poor's and Moody's, as sacrosanct.
‘You have got to be very careful that you manage the business and that Standard & Poor's or Moody's or what-have-you don't end up running the business [by] default,' said Mr Walsh.
‘I believe we have done all the things we need to retain an A-rating. But I am not about to be driven by a rating which takes into account things that we and our shareholders don't take into account.'
The Anglo-Australian miner expects to end the year with $19bn of net debt, down from $22bn in midyear but the same level as at the start of 2013. Its gross debt stood at $29.5bn at midyear.
Credit rating agencies' judgments have been increasingly called into question since the financial crisis, when they were viewed as having given overly reassuring ratings to many of the complex debt instruments that were at the heart of the crisis. Rio has long been focused on maintaining its single-A credit rating. S&P put the rating on ‘negative' outlook in February, citing risks that its debt, including costs for pensions or for mines at the end of their lives, could rise.
He acknowledged Rio's rating was ‘clearly an issue' for its borrowing costs.
‘It is not totally irrelevant but you cannot be driven by what others think you should be doing,' he said.FT
Source: Wilson, J. and Hume, N. (2013) Rio Tinto's Sam Walsh questions credit rating groups' relevance, Financial Times, 11 December.
How rating judgements are formed
The rating given to securities depends on the likelihood of payments of interest and/or capital not being paid (default) and in some cases on the extent to which the lender is protected in the event of a default by the loan contract, the recoverability of debt. Rating agencies say that they do not in the strictest sense give an opinion on the likelihood of default, but merely evaluate relative creditworthiness or relative likelihood of default, and because rating scales are relative, default rates for a rating grade fluctuate over time. Thus, a group of middle-rated bonds is expected to be consistent in having a lower rate of default than a group of lower-rated bonds, but they will not, year-after year, have a default rate of, say, 2.5% per year. With regard to the recovery rate (‘loss given default') element, much will depend on the extent of credit enhancements such as collateral backing, strength of covenants and priority ranking relative to other debt.
The agencies consider a wide range of quantitative and qualitative factors in determining the rating for a bond. The quantitative factors include the ratio of company assets to liabilities, cash flow generation and the amount of debt outstanding. Ratios such as the number of times profits exceed interest are likely to be considered, together with the extent to which shareholder funds in the business are greater than total debt. Also considered are funding diversity, profitability and liquidity of assets.
The qualitative factors include competitive position, quality of management, vulnerability to the economic cycle, dependence on one or a few products or customers, and geographic diversity - see Article 5.4 for a qualitative discussion of Microsoft's and Apple's relative default risk.