An Innovative Way to Borrow Started at Enron
The New York Times
January 29, 2002
MARKET PLACE
By DANIEL ALTMAN
What do AT&T (news/quote)
and British Airways
(news/quote) have in common
with Enron (news/quote)? All
three companies have borrowed
money in the financial markets
using credit-sensitive notes. The
notes are intended to send a
signal that a company is more
creditworthy than it appears, yet
they could end up actually
affecting its credit rating, or, in
dire circumstances, even
accelerating its demise.
Bear, Stearns, the securities firm,
says the $100 million in
credit-sensitive notes that it
helped Enron sell in 1989 were
the first ever. Institutional
Investor magazine named the
debt issue one of its "deals of the
year." The notes were set up to
pay interest of 9.5 percent, a rate that could have changed
with Enron's credit ratings. If either Standard & Poor's or
Moody's (news/quote) downgraded Enron's debt, the
notes would pay a higher return - up to 14 percent. If
both rating agencies upgraded Enron, the return would
fall slightly.
The bonds matured last June, with Enron's credit rating
never having moved enough to alter the coupon rate.
Much later in the year, rating downgrades helped push
Enron into filing for bankruptcy protection.
Several other companies have since taken a page from
Enron and issued similar notes, but these notes have
actually experienced the escalating payments. So far, the
payments have posed little threat to the companies'
bottom lines, but that could change.
British Airways issued £250 million, or about $356
million, in credit- sensitive notes in August at a coupon
rate of 7.25 percent. George Stinnes, who handles
investor relations at the company, said that investors
wanted credit sensitivity to insulate themselves from
worries about the air travel industry.
"At the time, there was some view that the airline industry
was going to go into a difficult patch," Mr. Stinnes said.
"And so, in the premarketing for the issue, the investors
felt that this was a feature that they wanted."
Since the issue, the rating on subordinated debt for
British Airways has been cut three times. Each time, the
company was obliged to raise the bonds' coupon rate 0.5
percentage point, to a current rate of 8.75 percent. The
additional cost of paying the higher coupons is £3.75
million, or about $5.3 million, each year. Over the 15-year
life of the bond, assuming the airline's credit rating does
not change again, the additional cost could add up to
one-fifth of the debt's face value.
Last November, AT&T sold $10 billion in bonds, all of
which had a credit-sensitive element. For each cut in
AT&T's credit rating, the coupon rate on the bonds
increases 0.25 percent. On Dec. 20, Standard & Poor's
dropped AT&T's credit rating by one notch, costing the
company $25 million more a year.
Enron used credit-sensitive notes to raise money at a
difficult time, said Sanjiv Das, a finance professor at Santa
Clara University who was a co-author of a case study on
the notes for Harvard Business School.
By the end of the 1980's, Professor Das said, the collapse
of Michael Milken's junk-bond empire had made
financing difficult for fast- growing companies. "A lot of
companies were on the cusp of junk and investment
grade," he said. "Nobody in that range could raise
financing."
By promising bigger coupon payments in the event of a
ratings downgrade, Enron offered the market a signal that
it expected its credit ratings to improve. "They were trying
to tell the market, `We know our company's better than
you think it is - if we're lying, we're going to pay for it,' "
Professor Das said.
Despite the rising popularity of credit-sensitive notes,
they are hard to value, says Darrell Duffie, a finance
professor at Stanford who has been a consultant for
Enron.
"They've actually caused some head-scratching in terms of
how to price them," said Professor Duffie, who has asked
his graduate students to derive a formula for valuation.
Part of the reason credit-sensitive notes are hard to value
is that they can bring increased risk. Companies whose
credit ratings fall usually have poor cash flow. But lower
ratings would produce higher coupon payments for a
credit-sensitive note and still more pressure on cash flow,
said Ian Giddy, a professor of finance at New York
University.
At some point, Professor Giddy said, the note "becomes
worthless, because the rating gets downgraded, the
interest is exorbitant and the company can't afford to pay
it."
"It's kind of a vicious circle," he said.
Glen Grabelsky, the managing director of the credit policy
group at Fitch IBCA, the rating agency, said that most
companies would not be driven to bankruptcy by
credit-sensitive notes. "Usually the interest payment in
relation to the cost structure of an organization is quite
small," he said.
But a company's decision to expose itself to additional
costs, as well as triggers that might speed repayment
deadlines, can loom large with analysts.
"People have always been aware that that kind of a step
has repercussions to it," said an analyst at a major rating
agency. When it comes time to consider a company's
rating, the analyst said, "It'll be just one more piece of
information to put onto the scale."
nytimes.com |
