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6/09/2021

FIN226 Tutorial Week 7

International debt markets

Chapter 11: Question 1 The euromarkets have expanded into a significant global market.

a. What is a euromarket transaction?  A euromarket transaction is a financial transaction conducted in a foreign country, but not denominated in the currency of that foreign country.

 For example, an Australian company issues bonds into the Singapore market that are denominated in GBP, or a Japanese investor deposits USD funds into an account of a Bank based in Zurich, Switzerland.

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Chapter 11: Question 4 The euronote market is a generic term that incorporates both note issuance facilities (NIF) and eurocommercial paper (ECP).

a. Describe the type of securities known as an NIF and an ECP.  Euronote market transactions are short- to medium-term debt instruments issued directly into the markets.  NIF and ECP are both euronote instruments; they are promissory notes issued by a borrower into overseas markets in a currency other than the currency of the country in which the paper is issued.  They are discount securities sold into the money markets at a price less than the face value; the face value is repayable at maturity.

Features Promisory Note One-name paper Discount security Maturities usually ranging 30-180 days Roll-over arrangement common Issue requires arranger, lead manager, co-managers, the facility manager, the tender panel, issuing and paying agent Issued in most currencies but mainly in USD Timing of issue and amount standing can be set to suit the cash flow requirements of the issuer and the market conditions Underwriting arrangements used Can be converted into a medium-term funding commitments Only borrowers with good reputation and strong credit rating can issue

NIF

ECP

Yes Yes Yes Yes Yes Yes

Yes Yes Yes Yes Yes Yes

Yes Yes

Yes Yes

Yes Yes No

No No Yes

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Chapter 11: Question 4 The euronote market is a generic term that incorporates both note issuance facilities (NIF) and eurocommercial paper (ECP). b. What features of these facilities are the same and in what ways do they differ from each another?

Similarities 1. Both are promissory notes – commonly referred to as commercial paper 2. Drawn (issued) by a borrower in its own name (one-name paper)

3. Discount securities – sold for less than the face value which is payable at maturity 4. Typically issued with maturities ranging from 30 to 180 days 5. Normally issued with a roll-over arrangement in place

6. Parties involved in an issue include the arranger, the lead manager, co-managers, the facility agent, the tender panel and the issuing and paying agent 7. Issued in most major currencies, but USD predominates 8. The value and the timing of an issue, and the amount of notes outstanding at any one time, can be finetuned to meet the issuer ’s cash flow requirements and the conditions prevailing in the market.

Chapter 11: Question 4 The euronote market is a generic term that incorporates both note issuance facilities (NIF) and eurocommercial paper (ECP). b. What features of these facilities are the same and in what ways do they differ from each another?

Differences 1. A NIF incorporates an underwriting arrangement; ECP does not. 2. A NIF is converted into a firm medium-term funding commitment by the participation of underwriting banks who are committed, up to the underwritten amount, to purchase any unsold notes at the issue and roll over dates. 3. As ECP are not underwritten, only those borrowers that have an established a good reputation in the euronote market and have a very strong credit rating are able to issue ECP successfully.

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Chapter 11: Question 4 The euronote market is a generic term that incorporates both note issuance facilities (NIF) and eurocommercial paper (ECP). C. BHP Billiton Limited is to issue ECP into the London euronote market. The 90-day ECP issue has a face value of USD100 million and a yield of 5.75 per cent per annum. Calculate the amount raised on issue by BHP Billiton.

Chapter 11: Question 12 Santos Limited is an Australian corporation listed on the ASX. Santos wishes to raise additional equity i n the USA, but is not dual-listed on the NYSE. The company’s financial advisers suggest th e company approach th e Bank of New York Mellon to arran ge a n issue of American de positary receipts (ADR). Explain the existence and operation of the ADR market. Demonstrate in your answer how a foreign company might raise funds in the US capital markets through a n ADR issue. • American de positary receipts are primarily a form of e quity issuance, although debt issue ADR programs a re possible. • A depositary receipt is a security issued by a US depository bank and is evidenced by a depository share. • A d epositary share will represent one or more shares of a foreign issu er which are listed on the foreign company’s local stock exchange. • Typically, a depositary share will represent more than one share of the foreign issuer where the domestic share is trading at a price lower than that to which US investors are accustomed. • An ADR program provides the opportunity for a foreign company, which otherwise may not have been able to meet SEC listing re quirements, to access th e US capital market to raise funds. • Given the size of the US capital markets, the ADR has become an important source of funding for foreign companies. • A d epositary ban k acts as administrator, depository, transfer agent and registrar for the program. Th e bank will assist with program structure and compliance issu es, issue depositary re ceipts, maintain records of registered holders, process transfers, process dividend payments and facilitate an orderly market. • The ADR market is deep and liquid. An ADR is attractive to US investors because the issue is quoted in USD, and associated cash flows (dividends or interest payments) are denominated in USD and therefore are protected for foreign e xchange risk. The issue is supported by the un derlying shares of th e issuer, a nd is subject to US legal jurisdiction.

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Chapter 11: Question 13 Credit rating agencies perform an important role within the international financial markets . a. Name three global credit rating agencies.

(i) Moody’s Investors Service (ii) Standard and Poor’s (iii) Fitch Ratings

Chapter 11: Question 13 Credit rating agencies perform an important role within the international financial markets . b. Discuss the purpose and importance of a credit rating issued by a credit rating agency on a corporate debt issue from the perspective of both a borrower and an investor. ( LO 11.6)  A credit rating is the opinion of a credit rating agency about the ability and willingness of an obligor, such as a corporation or government, to meet its financial commitments with respect to a debt issue or other financial obligation.  A credit rating is an opinion about the credit quality of an issue, such as a bond or other debt security, and the relative likelihood that it may default.  A credit rating is not a recommendation to an investor; rather it is a structured assessment process that differentiates the credit quality of debt issuers.

 A credit rating is not an indication of the market liquidity of a debt security or its price in the secondary market.  There are a number of major international credit rating agencies, including Standard and Poor's, Moody's Investors Service and Fitch Ratings.

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Chapter 11: Question 13……part b continued Credit rating agencies perform an important role within the international financial markets . b. Discuss the purpose and importance of a credit rating issued by a credit rating agency on a corporate debt issue from the perspective of both a borrower and an investor. ( LO 11.6)  The objective is to provide a standard measure of credit risk.  A rating agency issues both long -term and short-term credit ratings.  S&P long-term ratings range from AAA, reflecting the strongest credit quality, to D, the lowest. Ratings from AA to CCC may be modified by the addition of a plus or minus sign to show relative standing within the major rating categories.

 Debt issues with a rating of BBB and above are regarded as investment grade.  S&P short-term credit ratings range from A-1 to D.  While agencies will rate a corporation, most credit ratings are issue-specific.

Chapter 11: Question 13…part b continued Credit rating agencies perform an important role within the international financial markets . b. Discuss the purpose and importance of a credit rating issued by a credit rating agency on a corporate debt issue from the perspective of both a borrower and an investor. ( LO 11.6)

 The importance to an investor of a credit rating is that it provides a standard measure of risk. A credit rating of BBB has the same meaning no matter which international capital market it is issued. This assists with the pricing of investment opportunities, particularly in the international markets where the investor may not have full knowledge of the operations of a foreign corporation.  The importance to the issuer/borrower is that the credit rating is internationally accepted, therefore investors are more likely to buy securities that have a credit rating attached. There is a direct relationship between risk and return; the higher the credit rating the lower the yield the borrower needs to offer on the issue.

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Chapter 11: Question 13…part b continued Credit rating agencies perform an important role within the international financial markets . b. Discuss the purpose and importance of a credit rating issued by a credit rating agency on a corporate debt issue from the perspective of both a borrower and an investor. ( LO 11.6)

 The importance to an investor of a credit rating is that it provides a standard measure of risk. A credit rating of BBB has the same meaning no matter which international capital market it is issued. This assists with the pricing of investment opportunities, particularly in the international markets where the investor may not have full knowledge of the operations of a foreign corporation.  The importance to the issuer/borrower is that the credit rating is internationally accepted, therefore investors are more likely to buy securities that have a credit rating attached. There is a direct relationship between risk and return; the higher the credit rating the lower the yield the borrower needs to offer on the issue.

Chapter 11: Case study SUPERVIS ION OF RATING AGENCIES In Section 11.6 we considered the important role played by credit rating agencies in the global capital markets. In 2017, Moody’s, a US rating agency, agreed to pay $1.1 billion to settle claims regarding inflated ratings. In the middle of 2018, they made another agreement to resolve charges related to their issued ratings of mortgage-backed securities following an inquiry by the US Securities and Exchange Commission (SEC) (Michaels & Banerji, 2018). Credit ratings agencies came under increasing scrutiny following the GFC. The employees of credit rating agencies often revealed their frustrations over conflicts of interests arising from the issuer-pays model. Arguments were made that the rating agencies function under pressure from investment banks who pay fees to the ratings agencies in return for their ratings service. The implication, of course, is that ratings agencies are compelled to rate bond issues more favourably than they otherwise would in order to avoid losing the business to another agency (Cash, 2018).

In Australia, credit rating agencies need to hold an Australian Financial Services (AFS) licence. There exists six licensed CRAs in operation, namely AM Best Asia-Pacific Limited (AM Best), Australia Ratings Pty Ltd (Australia Ratings), Equifax Australasia Credit Ratings Pty Limited (Equifax), Fitch Australia Pty Limited (Fitch), Moody’s Investor Services Pty Limited (Moody’s) and S&P Global Ratings Australia Pty Ltd (S&P).

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Chapter 11: Case study SUPERVIS ION OF RATING AGENCIES …continued In February 2018, the Australian Securities and Investments Commission (ASIC) conducted a market-wide study of these credit rating agencies and made numerous recommendations. The study identified a conflict of interest that affects the credit rating methodology, judgment and analysis.

The recommendations focused on changing the corporate structure of agencies to reduce conflicts of interest and to maintain transparency. ASIC also recommended a series of changes, including practical management of conflicts of interest, regular agency board meetings to ensure compliance with licence requirements as well as the production of compliance reports containing details on testing and reviews (ASIC, 2018a). According to ASIC commissioner Cathie Armour, the credit rating agencies play a crucial role in the market by informing the market participants about the credit risks that inform their financing and investment decisions. It is important to ensure that the rating agencies operating in global markets do not lose sight of Australian regulations. ASIC actively participates in the supervisory colleges established for three international CRAs, namely Fitch, Moody’s and S&P. These supervisory colleges were established to enable information exchange between supervisors of internationally active CRAs to strengthen the supervision mechanisms (ASIC, 2018b).

Chapter 11: Case study 1. Discuss why credit rating agencies may come under pressure to provide higher bond ratings.

• Most importantly, credit rating agencies earn fees by providing ratings on products. • They can face pressure to provide higher ratings when customers (e.g. investment banks) imply that they will take a product to a different ratings agency if a desirable rating is not awarded. • Following the GFC, there were strong implications that this had occurred with regards to some mortgage-backed securities products.

• A number of articles emerged following the GFC, including this one that explores the conflicts of interest that some people believe ratings agencies have: https://www.theguardian.com/business/2011/aug/22/ratings -agencies-conflictof-interest

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Chapter 11: Case study 2. Discuss the supervision mechanisms implemented by ASIC for credit ratings agencies operating in Australia. •

In 2018, ASIC announced the results of a review into ratings agency supervision in Australia: https://asic.gov.au/aboutasic/news-centre/find-a-media-release/2018-releases/18-042mr-asic-reports-on -credit-rating-agencies/.

•

Some of the provisions set down by ASIC are aimed at reducing or removing conflicts of interest .

•

According to REP566 Surveillance of Credit Rating Agencies (CRAs), ASIC’s four objectives are:

(a) Quality and integrity of the rating process: CRAs should endeavour to issue opinions that help reduce the asymmetry of information among borrowers, lenders and other market users. (b) Independence and conflicts of interest: CRA ratings decisions should be independent and free from political or economic pressures and from conflicts of interest arising due to the CRA’s ownership structure, business or financial activities, or the financial interests of the CRA’s employees. CRAs should, as far as possible, avoid activities, procedures or relationships that may compromise or appear to compromise the independence and objectivity of the credit rating operations.

Chapter 11: Case study 2. Discuss the supervision mechanisms implemented by ASIC for credit ratings agencies operating in Australia. (c) Transparency and timeliness of ratings disclosure: CRAs should make disclosure and transparency an objective in their ratings activities. (d) Confidential information: CRAs should maintain in confidence all non-public information communicated to them by any issuer, or its agents, under the terms of a confidentiality agreement or otherwise under a mutual understanding that the information is shared confidentially. The full report can be found at: https://download.asic.gov.au/media/4644648/rep-566-published-15-february-2018.pdf

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