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S&P, Moody’s, Fitch: What is the rating agencies’ logic?

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Standard and Poor’s (S&P) has just affirmed, on Friday, June 2, 2023, France’s AA rating. Thus, the world’s leading rating agency is out of line with Fitch, which downgraded its rating on April 28 from AA to AA-.

Rating agencies also rate the companies that apply. The rating is mandatory for any issuer of ordinary bonds that are intended to be listed on an exchange. So what is the logic of the rating agencies?

The reasons for the deterioration in the rating by Fitch were clear: first, the ratios that deviated from the levels stipulated in the Stability and Growth Pact. Thus, at the end of 2022, France’s public debt is close to 3,000 billion euros. This represents 111.6% of GDP, while the public debt of AA-rated countries accounts for a smaller share of GDP. According to the Stability and Growth Pact, this percentage should historically be set at 60%. Moreover, France’s public deficit was 4.7% of GDP. This percentage should be increased to 4.9% at the end of 2023 according to government expectations, while the Stability and Growth Pact has set its ceiling at 3%. According to Fitch Agency, the reasons for this new increase in the deficit relative to GDP are as follows: slowing economic growth and increasing public spending due to inflation. But Fitch also insists on two points. The first is to express skepticism about the government’s growth assumptions, which are considered optimistic and which would make it possible to reduce the deficit to 2.7% of GDP, less than 3%, in 2027. The second is the deterioration of the social climate after the pension reform. This makes Fitch fear new budget slides.

Standard & Poor’s, for its part, justifies maintaining its AA rating by reviewing the government’s budget strategy. In particular, the pension reform and the scheduled end of energy subsidies lend credence to the government’s deficit-reduction goals. However, Standard & Poor’s, like Fitch, stresses the absence of an absolute government majority in the National Assembly. Such a situation limits its ability to advance new reforms needed to reduce debt and deficits. This is why Standard & Poor’s certainly maintains its AA rating but also its “negative” outlook. In other words, its rating is not immune from downgrading in the future.

The rating downgrade by Fitch did not lead to an increase in the rate of Assimilables du Trésor (OAT) bonds issued by the country to finance its budget deficit. Continued swimming in the S&P should confirm that there is no increase in the cost of debt for the country. As a reminder, within the Eurozone, only 5 countries have a better rating than France: Germany, the Netherlands and Luxembourg benefit from the highest AAA rating; In addition, Austria and Finland are rated AA+. With an AA rating, France is on the same level as Belgium. In addition, the United Kingdom, outside the Eurozone, is also rated AA. In addition, Moody’s indicated, at the end of last April, that it had not revised its rating of France.

The rating expresses the agency’s opinion regarding the credit or counterparty risk to which an investor is exposed in debt securities. When the bond issuer is a corporation, the rating is based on different criteria than those used to assess a nation’s economic health. In the case of a company, a certain number of financial indicators make it possible to assess the risk of default which could lead to losses for its creditors. For example, for the auto industry, Moody’s scan is 4 points.

The first point is the company’s economic profile. This determines its ability to generate stable cash flows sustainably. This is based on the attractiveness of its product portfolio, which ensures the maintenance of its market share. The rating then takes into account its efforts to invest in new technologies that enhance strategic differentiation. In addition, in the case of the auto industry, a strong presence in 4 major markets allows for better flexibility in the event of an economic downturn. These markets are Europe, North America, China and Japan,

Profits are used to support marketing expenses, research and development costs, and investments in human capital. Thus, the second point is to analyze the company’s profitability and efficiency. This analysis is based on the ratio comparing EBITA (Earnings before interest, taxes and amortization) and its rotation. This ratio is close to the EBITDA margin rate, since EBITA is reduced solely by depreciation charges on property, plant and equipment.

The third point revolves around the financial leverage that determines the financial flexibility of the company. It is also a condition of his survival. To do this, the rating agency calculates 5 ratios: Debt/EBITA, Cash Assets/Debt, Cash Flow/Debt, Free Cash Flow/Debt and EBITA/Financial Expenses.

The fourth point is the analysis of fiscal policy. It is then a question of assessing the company’s management’s tolerance for financial risks. Particular attention is also given to its ability to implement the necessary measures, when required, to restore the financial structure that was particularly prevalent prior to mergers and acquisitions.

Each of these four points contributes respectively to 40%, 20%, 30% and 10% of the company’s final rating.

Accordingly, the classification is based on a methodology that is explained according to the type of issuer of debt securities, and for companies, according to the sector of activity. The logic of a country’s classification depends mainly on its ability to ensure economic development while respecting the main budget balances. The company’s ability is focused on its ability to generate cash flow and access to external financing, in order to avoid default.

Olivier Levin is an affiliate professor at HEC Paris

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