For companies whose debt level falls to “junk” status, Moody’s Investors Service plans to begin assigning “Speculative Grade Liquidity Ratings,” or SGLs, to isolate its opinion of an issuer’s liquidity risk. The ratings will specifically rate a junk-rated company’s liquidity over a 12-month period using four grades, from “very good” to “weak.”

The rating process for assigning SGL ratings will be the same as that for long-term debt ratings. All liquidity rating assignments will go through Moody’s rating committee process, and public notice will be given every time an SGL rating is assigned, changed or confirmed.

“The key short-term liquidity risk for the speculative grade issuer is its ability to meet its obligations through its internal resources and the availability of committed sources of financing,” said Mike Rowan, group managing director. “The SGL ratings have been developed to evaluate these elements of the speculative grade issuer’s liquidity.”

Assessing the liquidity of a company is already a “core element” of the senior implied, leveraged loan and high-yield bond ratings, he said, and it “heavily affects Moody’s opinion of an issuer’s probability of default.” In turn, the probability of a default is part of the senior implied rating, reflecting both the probability as well as the “severity of loss” if that happened. The probability of default depends on an issuer’s capacity to meet obligations, as well as its willingness to meet obligations. “The new SGL ratings will capture Moody’s opinion of an issuer’s capacity to meet obligations.”

Adding an SGL rating came in response to what the fixed-income market participants wanted. They were requesting more information on the liquidity of junk-rated companies because default rates have remained high over the past year. Moody’s said the additional research will be performed through its Liquidity Risk Assessment (LRA), introduced earlier this year. Separate liquidity opinion products address specific issues “that are of most relevance to the discrete segments of the capital markets.” Both the SGL and LRA evaluate an issuer’s free cash flow, cash on hand and committed sources of financing, in relation to its obligations coming due, over the next 12 months.

In assessing projected cash flow, Moody’s will consider performance volatility from industrial cycles, seasonal demands, competitive position and the need for investment in operations in order to meet growth objectives. If cash flow falls short of projections, Moody’s also will assess the alternative sources of liquidity available to cover shortfalls. “For speculative grade issuers, a committed bank line is the primary source of alternative liquidity.”

Rowan said that the analysis of an issuer’s ability to “maintain orderly access to this source of funding includes an analysis of future compliance with financial covenants, an evaluation of material adverse change (MAC) clauses, triggers and other conditions that could constrict access to the line of credit.”

SGL ratings will run from SGL-1, which is very good, to SGL-4, which is weak. SGL-1 ratings would apply to companies most likely to have the capacity to meet their obligations over the coming 12 months through internal resources without relying on external sources of committed financing.” Those with an SGL-2 “possess good liquidity,” and likely would meet obligations over the 12 months through internal resources, but could rely on external sources of committed financing. “The issuer’s ability to access committed sources of financing is highly likely based on Moody’s evaluation of near-term covenant compliance.”

A SGL-3 rating would indicate “adequate” liquidity, with companies relying on external sources of committed financing. “Based on its evaluation of near-term covenant compliance, Moody’s believes there is only a modest cushion, and the issuer may require covenant relief in order to maintain orderly access to funding lines. Finally, those falling into the SGL-4 have weak liquidity, and would rely on “external sources of financing and the availability of that financing is, in Moody’s opinion, highly uncertain.”

Responding to the new ratings system, Louise Purtle, U.S. credit strategist for CreditSights Inc., an independent fixed-income research service, said that more information about liquidity would be beneficial if it is applied consistently. “The only negative could be if that several companies share a debt rating but have vastly different liquidity ratings, the market could struggle to determine which rating to focus on in pricing debt securities,” she said.

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