With a string of innovatively structured deals in the pipeline, Fitch is stepping up its rating methodologies by increasing its focus on enhanced recovery rates in emerging markets.
In an article in the Fitch Global Securitization Quarterly, written by Gregory Kabance, senior director at Fitch, the integration of new products into the market have prompted the company to rethink the way hybrid structured transactions - deals that incorporate structural and corporate features - are rated.
The new concept of partial guarantees, instilled by market players like the International Finance Corp. (IFC) and the World Bank, have jumpstarted creativity in the way deals are structured. "The catalysts are really the IFC and other players in the market that are offering partial guarantees to transactions and that's why we started re-thinking - how do we give benefit to that?" Kabance said.
The re-evaluated rating method does not pertain to partial credit guarantees on the sovereign, as has been done in Argentina and Thailand; rather it applies to private corporate sector transactions that have a 30% or 40% guarantee. Historically the transactions that have come to market in emerging markets have not incorporated this type of partial guarantee although there are currently some in the pipeline.
Another new product in the works which has instigated Fitch's re-evaluation is derivative products like hedge agreements.
These benefits will boost ratings about one or two notches higher. The article cites this example: If Fitch estimates the underlying corporate entity to have a 30% recovery and has a partial guarantee from a highly rated entity covering 30% of the outstanding notes, then we believe the total recovery to be 60% and therefore, credit enhanced transactions would be rated one notch higher than without the enhancement.
Although these new products do not lower the risk of default, they do lower the loss that investors will have to swallow. "As a rating agency we certainly believe that the probability of default is the key concern, but if the severity of default is improved dramatically, we should reflect this as well," Kabance said.
Information on recovery rates throughout emerging markets is difficult to interpret because the standard deviation has been wide and the information is scarce. Fitch is currently conducting a study in Mexico to ensure a more accurate average of recovery rates.
