Market-linked notes (MLNs) are broadly defined to include instruments where interest and/or principal repayments are linked to an equity, currency, commodity, or market price index, or to the market value of a particular stock or fund. Repayments of MLNs can also be linked to baskets of any of the above.
This article discusses Standard & Poor's current policies for rating MLNs and seeks feedback on proposed changes in these policies. Standard & Poor's is currently reviewing its policies with respect to credit-linked debt and will be publishing updated criteria on rating those instruments at a later date.
As a matter of general policy, as discussed more fully below, Standard & Poor's rates MLNs based on the likelihood that principal will be paid according to the terms of the instrument, even though required payments may differ substantially based on the performance of the index or market price. An MLN's credit rating reflects the creditworthiness of the issuer (or guarantor), but not the market risk that the investor bears as a consequence of the terms of the instrument.
As MLNs are appearing more frequently and have become more complex, we are seeking comments as to whether the market would find added value in an additional notation regarding market risk to the principal of these instruments. Standard & Poor's also seeks comments on a potential modification of its current rating approach to MLNs when repayment is linked to the equity performance of a single reference entity or a small pool of reference entities.
Background
When MLNs were first introduced in the marketplace, Standard & Poor's required that minimum terms?a minimum stated interest rate and a full return of principal?be present in rated fixed-income instruments. This assured that a rated instrument retained the fundamental attributes of a fixed-income instrument, namely a guaranteed return of principal and a minimum return. Standard & Poor's dropped the minimum requirements in 1994, but attached an 'r' subscript to the rating of MLNs to alert rating users to the potentially significant market risk embedded in these instruments. As these instruments became widely accepted and market participants became accustomed to instruments with embedded derivative risk, Standard & Poor's discontinued the 'r' subscript in early 2000. The policy in place since then has reflected Standard & Poor's belief that investors understood their terms (when properly disclosed) and also understood that the credit rating only applies to the likelihood of payment according to the terms.
Standard & Poor's has always emphasized that the credit rating of a MLN reflects the creditworthiness of the issuer (or guarantor). These ratings do not, however, encompass the market risk?interest rate risk, equity risk, or other?inherent in the repayment terms of the instrument. In many instruments, and in MLNs in particular, the market risks may be far greater than the credit risks. Standard & Poor's cautions market participants not to assume that instruments with similar tenors and identical ratings have the same overall risk profiles. While the credit risk of the hypothetical instruments in this case would be similar, the market risk could be vastly different.
This message of caution is all the more important in light of the increasing complexity of issue terms and the movement toward the convergence of the debt and equity markets. Standard & Poor's media releases on large, publicly sold and rated MLN issues will continue to emphasize that the rating applies only to the likelihood of payment according to terms.
The rating of an MLN reflects Standard & Poor's opinion about the capacity and willingness of the issuer to honor the terms of the MLN. Standard & Poor's adheres to reasonable standards of disclosure for rating MLNs, that is, the terms of the note and settlement must be clear and not subject to material arbitrary modification on the part of the issuer. The reference index for index-linked notes must be readily accessible by investors, independent, and ultimately verifiable. Standard & Poor's expects that for discrete, publicly issued MLNs, the linkage will be clearly and prominently disclosed in the prospectus or offering memorandum.
Examples
The following examples of MLNs are designed to illustrate the policy. Unless otherwise stated, the terms of the examples are clear and recognizable in the offering documents.
Fixed Interest Rate, Repayment of Principal Linked to Equity Index
Investment Bank X, which has 'A+' counterparty and senior debt ratings, issues an MTN out of its shelf offering with a fixed interest rate. The amount of principal repayment varies based on the performance of the S&P 500 during the period. The note will be rated 'A+' based on the creditworthiness of the issuing bank.
Variable Interest Rate, Repayment of Principal Linked to Equity Index
Investment Bank X issues an MTN out of its shelf offering with an interest rate that varies based on the dividend yield of the S&P 500. The amount of principal repayment varies based on the performance of the S&P 500 during the period. The note will be rated 'A+' based on the creditworthiness of the issuing bank.
Variable Interest Rate, Principal Payment Varies on Price of Commodity
Investment Bank X issues notes with an interest rate that varies based on LIBOR. The principal payment varies based on the closing price of a particular gold contract on the New York Mercantile Exchange. The note will be rated 'A+' based on the creditworthiness of Issuing Bank X.
Principal Repayment Tied to a Range of Values
Investment Bank X issues US$ bonds that are linked to the Colombian peso (CoP) within a range. At the time of issuance, the exchange rate was CoP2,800 to US$1. At maturity, Investment Bank Y promises to repay a minimum of US$875 per bond if the exchange rate is CoP3,200 or more to US$1, and up to US$1,120 if the exchange rate is CoP2,500 or less to US$1. The bonds will be rated 'A+' based on the creditworthiness of Issuing Bank X.
Principal Repayment not Guaranteed
Investment Bank X issues zero-coupon notes with principal payment inversely related to yields on the 10-year U.S. Treasury note as reported in the Wall Street Journal. At maturity, the repayment amount can vary between $1,100 per $1,000 bond if the yield is less than 4%, and zero if the yield is more than 5%. The notes will be rated 'A+' based on Investment Bank X's ability to honor the terms, even though the investor may receive nothing.
Obscure or Unclear Reference to the Linked Entity
Investment Bank Z, which has 'A' counterparty and senior debt ratings, issues Colombian peso-linked notes that are linked to the exchange rate of the peso, similar to the notes discussed in the fourth example above. In this case, however, the title of the bonds makes no reference to the peso link, the cover page of the prospectus makes only a vague reference, and the link is not defined until page 10 of the prospectus. Since the terms of the MLNs are unclear, Standard & Poor's will not publicly rate the notes. However, Standard & Poor's could rate these notes if they were privately placed.
Emerging Risks In MLNs
MLNs have grown increasingly complex. Many notes include provisions that allow the issuer, or the calculating agent, the discretion to change the calculation or valuation of the reference index, and, consequently, the payment terms of the MLN. Depending upon the degree of discretion provided, such provisions may introduce potential conflict. Standard & Poor's views this as an emerging risk in the MLN market, mitigated by the institutional nature of the market and by the separation of the calculating agent role from that of the issuer. Nonetheless, Standard & Poor's may decline to rate discrete, public issues where the issuer can change materially the index and payment terms.
The repayment of some MLNs depends on the credit performance of a hedge counterparty of the issuer. Consequently, the creditworthiness of the counterparty could affect the timing or amount of repayment. If the hedge counterparty is not disclosed, its creditworthiness cannot be incorporated into the rating of the MLN. If the repayment of an MLN is subject to an undisclosed or unclear third-party credit risk, then Standard & Poor's will not rate the MLN.
Standard & Poor's Solicits Comments
Due to the proliferation and increasing complexity of MLNs, particularly those issued from MTN issuance programs of financial institutions, Standard & Poor's is updating its ratings policies on MLNs.
Standard & Poor's requests the views of market participants on the benefits of additional ratings disclosure with respect to MLNs that entail a high degree of market risk, notably when principal repayment is linked to the performance of an equity, commodity, or other index, and the MLN therefore may repay only a fraction of the initial principal investment.
Initially, Standard & Poor's used a ratings subscript to assist market participants in identifying risks in MLNs. As the risks inherent in MLNs became widely accepted, we suspended use of the subscript. We now see additional risks emerging in MLNs, as we discussed above, and solicit market comments to inform our future policy determinations.
Standard & Poor's also seeks comments on a potential modification of its current ratings approach to MLNs with repayment linked to the equity performance of a single reference entity or a small pool of reference entities.
We will revise ratings criteria on these instruments to incorporate the equity risk. We are considering using the issuer rating of the referenced equity as a proxy for the equity risk. Standard & Poor's regards MLNs linked to individual equities as unique among MLNs given the correlation observed between equity performance and creditworthiness and the established criteria framework for rating equity default swaps, which incorporate payment terms linked to equity price decline events. The default of a referenced entity in an MLN would necessarily imply an impairment to the equity of the reference entity. Moreover, Standard & Poor's current policy for the treatment of a single equity as a market reference creates the unusual and counterintuitive circumstance of having an instrument linked to a referenced company's equity rated higher than the debt of the reference company.
Comments on the proposed changes may be sent through April 25, 2005 to criteriacomments@standardandpoors.com.
