In efforts to enhance rating methodologies, Standard and Poor's has changed its weakest link method and it seems as though emerging markets stand to gain the most from the new process.
The essential difference is that the new methodology focuses on the probability of receiving the cashflow on the bonds, versus the probability of initial default. The change will primarily impact new issues, surveillance and certain emerging market transactions.
As new trends will have it, the much talked about idea of partial guarantees is becoming more attractive to market participants. Prior to the new method, S&P did not factor such guarantees into the rating methodologies - transactions with partial guarantees were rated in the same way as deals without them.
"The primary reason was the weak-link approach," said Tom Gillis, managing director of structured finance at S&P. "We addressed what is commonly referred to as the first dollar of default, where the probability of default is the same as the weakest link whether you have a partial guarantee or no guarantee." However, a Latin American analyst at S&P said that the company is now acknowledging that debt with a partial guarantee is better than debt without a partial guarantee.
"The emerging markets tend to have issuers who would like to enhance their rating as high as they can, and this may provide an economic way to do that," said Gillis.
In addition, the change was also inspired by the recent flood of complex credit derivative proposals that have been presented to the agency. Gillis offered this example: if a double-A-rated issuer sold a bond where the interest was linked to the performance of three double-B rated countries, the bond would be considered a double-B bond, despite the fact that the principal was an obligation of a double-A-rated issuer. Furthermore, the likelihood of all three BB' countries defaulting was less than a single obligor defaulting at BB'. "So [the old method] didn't fit neatly into any of our traditional methodologies," Gillis said. "We wanted to have some way to better convey what the real risk would be to a bondholder in that type of instrument."
Currently, there are no outstanding transactions with partial guarantees that will be affected by S&P's new methodology. "Because we didn't recognize or give credit to partial guarantees, it didn't make a lot of economic sense for [issuers] to pursue that," Gillis said. "So that's why I don't think that there's a lot of them in the market.
But now that we will give credit to that in our rating process, you may see more. I don't think we have rated a bond with this method, but there are proposals on the method that we are responding to right now."