Credit rating boom: Mexican companies and governments line up for the service.

AS MEXICO'S financial system becomes more mature and more sophisticated, demand has exploded for a service that has been pretty much ignored by everyone except large institutional investors: credit rating.

International credit rating is dominated by a Big Three--Standard & Poor's, Moody's Investor Services and Fitch Ratings. They are in the business of evaluating the creditworthiness of their clients.

Francisco de la Selva, director of Business Development for Fitch Ratings in Mexico, says his company has experienced a tenfold increase in business since it set up shop here in 1997--from US$ 700,000 to 7 million dollars; the other agencies are growing apace as well.

Increasingly, Mexican companies and governments that want credit are finding that to get the most favorable terms, they need to approach investors with a credit rating in hand. For many investors here and abroad it's a must if talks are even to begin.

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As Mexico's financial situation continues to stabilize, growing numbers of international investors are buying Mexican credit instruments, in pesos or dollars, and companies are looking more to the financial marketplace instead of the banks for funds.

The pool of potential investors has grown dramatically since 2002. That's the year the rating institutions declared that Mexico had recovered sufficiently from the 1994-95 peso crisis for its sovereign debt to be awarded an "investment grade" rating. This designation opens doors because many mutual funds and pension funds have internal or external regulations stipulating that they can only invest in countries and institutions that have it.

Manuel Guerena, director of Industrial Ratings at Standard & Poor's in Mexico, said that in 2001 just one Mexican bond issue was floated, for 1.5 billion pesos, or about US$ 136 million dollars. So far this year there have been 255 bond issues for a total of 336 billion pesos, or more than 30 billion dollars. Each issuer needs a credit rating before it goes to the market.

It's not that bank credit is declining--it's not. But, Guerena pointed out, while corporate bank loans grew by just 12 percent last year, debt market issues nearly quadrupled.

Just a few years ago, it was impossible for a Mexican company or the government to sell bonds with a maturity longer than five years. It's another sign of investor confidence that bonds of 10, 15, and even 20 years are successfully marketed today.

It's not only the corporations that are lining up for ratings: De la Selva said one of the leading sources of new business comes from state and municipal governments seeking credit on the financial markets.

Alberto Jones Tamayo, general director of Moody's Mexico, said "sub-sovereign credits"--that is, loans to state and local governments and the companies they own--have been increasing for the past two years, as have structured transactions.

Administrators of pension funds (Afores) are restricted by regulation to buying securities only from companies that have been evaluated by at least two credit rating institutions.

ANOTHER OPPORTUNITY

There's even more good news on the horizon for the credit rating firms.

As of mid-September Congress was poised to pass the Law of Securities Markets (Ley de Mercados de Valores). One of the purposes of this law is to entice more Mexican companies to raise capital by issuing an Initial Public Offering (IPO) of shares on the Mexican Stock Exchange (BMV).

If passed as it now stands, the new law will make it easier for firms to list their shares. However, they will still have to get a credit rating before they can do so, just as they would if they were to issue Certificates of Deposit, or bonds, on the exchange.

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Due to an anomaly in Mexico's credit market, big borrowers sometimes get credit here at rates that are actually below those of similarly creditworthy entities in the United States.

"There is a bias to concentrate lending or financing into the Mexican investment grade companies," explained Jones Tamayo. "There is an excess of loanable funds. Investors in the country still do not discern between investment grade and speculative grade. Therefore, they neglect to take advantage of the high yield companies that can be part of an appropriately balanced portfolio."

The international flow of capital is likely to correct that before long. The evidence is that venture capital companies and private equity investors from abroad are already entering the local market.

Credit rating institutions analyze four types of entities: corporations, financial institutions and funds, structured finance (securitizations, where groups of small loans are bundled together and marketed as a package), and public finance groups--governments and government-owned companies like Pemex (Petroleos Mexicanos) and the Federal Electricity Commission (CFE).

A client requesting an overall credit rating will find that the report it receives is based on both internal and external factors.

Internally, analysts examine an entity's recent financial history and its before-tax profits and cash flow to determine its ability to pay interest and principle on its debt. If the review is linked to a planned bond issue, the analysis will focus on the risk for the new issue--that is, taking into consideration more senior obligations that must be paid out before the new issue bondholders would receive their money in case of default.

External factors include items like a company's market share and relative performance in its sector; the robustness of the sector or sectors in which a company does business or, in the case of government, the sectors most important to the tax base: factor prices; the current economic climate; and overall financial conditions in Mexico and the world.

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Since many external events (like Hurricane Katrina) are unpredictable and the markets for many sectors are cyclical, an entity's credit rating can change for better or worse even if the internal factors remain stable.

One of the external factors is "country risk." That's the spread between what the market will pay for bonds from a sovereign entity and the worldwide benchmark, U.S. Treasury Bills. Mexico's country risk has been below 200 basis points, or hundredths of a percent, throughout 2005. In mid-September it hit an all-time low of 136, down from more than 1,000 in 1995, in the wake of the peso crisis.

A new client is assigned an initial rating which is then reviewed and updated every few months.

One of the main criteria for arriving at a rating, and the one the client is best able to control or influence, is financial strength--the capital stock or tax base in relation to the total amount of debt an entity has taken on. This ratio, along with cash flow, is a strong indicator of its ability to pay the interest and repay the principle.

No single analyst makes the final decision on the credit designation to be given. That is done by a Credit Committee, a group of analysts who review and discuss the data.

Although the credit rating may be indispensable for the entity that seeks it, the rating agencies view the investor as its final client. The ratings firms charge a fee for this information in the United States, but in Mexico, the ratings are available free of charge.

"It is essential to understand that Moody's works for the investors," said Jones Tamayo. "What a company can expect is a fair opinion based on facts, numbers and market comparison consideration."

"The customer is the investor," agreed De la Selva. "The investor is the one who's interested in what we have to say about a company in terms of credit. The company and the municipality pay us, but at the end the customer is a client. That's the big responsibility that we have."

And a big responsibility it is: The firms that seek a rating have good reasons for doing so, but it's the investors who rely on those credit reports when they put their money on the line.

RELATED ARTICLE: Playing the Ratings Game

GETTING A CREDIT rating for your company is a straightforward process and it doesn't take long.

"It takes six weeks after we have received all the information," said Francisco de la Selva, director of Business Development for Fitch Ratings.

"All the information" includes the company's economic, legal and financial information.

Moody's requires a company's financial statements for at least the previous three fiscal years; detailed notes to those statements; qualitative presentations on the company's perception of its strengths and situation in the market; and its forecast and strategy for the future, said Alberto Jones Tamayo, the firm's general director for Mexico.

Because credit rating companies do not do detailed investigations or on-site visits--a process known as due diligence--that many lenders carry out to verify the data, all legal documents submitted must be notarized and all financial statements audited.

Companies that have not previously been audited might need to have their auditor review the last three years of company records before submitting them.

The credit rating agency assigns an analyst to review the documents and make a recommendation on the rating to be assigned.

However, the analyst does not have the final word. He or she will present the recommendations to a Credit Committee. At Fitch, the credit committee is normally comprised of directors, the analyst who reviewed the company and other analysts. For companies with international interests, an analyst from the United States might also take part. Sometimes the client is invited to talk to the credit committee.

At Moody's, said Jones Tamayo, "credit committees are comprised of analysts from anywhere in the globe that are specialists in the economic sector where the issuer belongs. All votes count equally irrespective of the hierarchical level of the participants."

The rating classifications vary slightly from one agency to another, but they are similar.

At Standard & Poor's, investment grade ratings are AAA, AA, A and BBB. Below that are designations of BB, B, CCC and CC.

What happens if your credit rating doesn't make it into the investment grade category? A lower rating can result in higher interest payments or, in Mexico, where investors are more oriented toward investment grade, a more difficult time to find credit.

That's where a credit rating firm's services can be useful: They offer concrete advice on what the company needs to focus on to improve its financial ratios.

"We look at the good things we see in the company and the bad things we see in the company," said De la Selva. "We see an area for growth and improvement in the quality of the company, and improvement of your credit quality ... We provide a lot of information on what we are seeing in the company, a general overview."

Once the credit rating is established, it is updated periodically, though the client will be asked to provide its quarterly financial statements.

Most reports are updated every three to six months, depending on whether the company is undergoing changes or if it is in a volatile sector. Manuel Guerena, director of Industrial Ratings at Standard & Poor's in Mexico, said the bread maker Bimbo is in a relatively stable sector and its sales continue to grow, so its report is updated less frequently than that of American Mobil, the cell phone service provider, where growth is good but competition is fierce.

What does all this cost? It varies with the complexity of the company being rated, but at Fitch most firms pay a flat rate, which ranges from US$ 15,000 to US$ 20,000 for the initial rating, and an annual fee of the same amount to take care of the updates.

At S & P the fees usually come in at about one percent of the amount of the credit sought, and the annual update fee will be the same.