Moody's Corporation (MCO) Earnings Call Transcript & Summary

Operator, just checking. Are we live and ready to go?

Okay. Mark, I think we are live. Good morning. Hello, everybody. Thank you for joining us virtually today. My name is Patrick O'Shaughnessy, and I'm the Capital Markets analyst here at Raymond James. I'm pleased to be hosting mark -- Moody's Mark Kaye for roughly 40-minute of fireside chat style discussion this morning. I believe that there is some functional reviewers to e-mail and make questions that might arise during our discussion. So I'll attempt to circle back to some of those as we progress through the conversation. With that, I'd like to get things underway. So Mark, thank you for being here.

Patrick, thank you very much for hosting me this morning and to Raymond James for the conference. Thank you.

Terrific. So I'd like to begin the conversation by focusing on some of the long-term drivers for your Ratings business. For the last 10-plus years, Moody's has benefited from the long-term tailwind of rising corporate leverage. How sustainable does Moody's see the current level of corporate leverage? And does the answer differ at all between investment grade and high yield or U.S. versus non-U.S.?

So I'm going to reference Slide 19 from our second quarter 2020 investor deck to assist me in the answer here. I think that corporates have been deleveraging the last decade. And this is certainly something that we watch closely. Furthermore, there are normal cyclical patterns to corporate leverage, as you can see on the slide, where we should find nonfinancial, speculative grade corporate leverage metrics back to 2006. While there's still a high degree of uncertainty, given the scale and speed of Central Bank and government stimulus this year, I don't know that I would expect to see deleveraging back to the 2009 and 2010 levels. And this certainly holds true for both the U.S. and non-U.S. We could see a scenario where, due to protracted uncertainty, all based on experience from recent volatility experienced in the debt markets in March, corporates decide to keep more cash on hand and operate with higher leverage. It is worth noting that it has implications for defaults, despite the increase in leverage, but we haven't necessarily seen a deterioration in financial coverage data. And I think part of this trend has been around -- or has been less of a function of corporates leveraging up heavily and more reflection of greater access to the capital markets for more highly leveraged companies. Our research reports have been writing about consistent or writing about this consistently over the past few years, specifically, that a greater portion of speculative grade issuers coming to the market. From memory, as much as 40% to 50% in some recent years, where is at lower end of the speculative grade spectrum. Not because less speculative grade issuers were at the higher end, but more due to efficiency of the market for some of these lower quality credits. I could say that this could be part of the normal cyclical phenomenon, and so you would expect some of those issuers access to the market to decline in times of greater stress and wider spreads. Lastly, I'd say, specifically for investment grade, we have seen a steady increase in leverage among investment-grade corporates, but that has been a deliberate decision by those companies to move more efficiently to deploy their balance sheets. The spreads between the higher end of investment grade and the middle of the range has compressed significantly over the last few years. That said, mitigating that increased leverage is the fact that BAA corporates generated more revenue, had higher EBITDA margins and great EBITDA interest expense coverage at 2017 -- sorry, 2018 compared to 2007, for example. So there are bigger companies with more levers to protect their cash flow, if needed.

Great. And you touched on coverage and how interest coverage remains very healthy in the current environment. To what extent does the sustainability of current corporate leverage levels depend on the view that the Fed and other Central Banks can't or won't let interest rates meaningfully rise?

The actions of the Federal Reserve have certainly served to improve market liquidity and to tighten credit spreads. I think that where there could be a possible impact would be around spread expectations. So for example, if corporates were anticipating greater divergence between spreads, so that could be a motivating factor to move up on the credit quality scale to obtain more efficient financing. The expectation of rates obviously remaining lower for longer and stable spreads could lend lead corporates to be more comfortable with the status quo of the balance sheet.

Got it. So if companies did need to undo -- unwind their leverage, and I think you've created a pretty compelling case that they don't intend to and that they don't need to. But if they did, and when you look at past periods when companies unwind their leverage, maybe because interest rates went higher maybe for other reasons, how does that leverage unwind typically work? Is it that they just kind of grow into it by growing their EBITDA, or does some of that debt need to go away? And then how has deleveraging in past cycles -- what were the implications of that for Moody's Corporate Finance Ratings revenues?

Patrick, that's a great question. While there are, I would say, a handful of large corporate issuers with large cash balances that could be used to repay current maturity, most corporates operate with relatively efficient balance sheet. And as a result, they may not have large amounts of cash in hand to repay maturities. Those borrowers who have recently accessed the capital markets and may have cash on hand could use that cash to pay down maturing debt. Alternatively, we could see a scenario where, due to protracted uncertainty, all based on experiences from recent volatility experienced in the debt market in March, corporates actually decide to keep more cash on hand and operate with slightly higher leverage. Most of the time, the capital market debt is going -- sorry, most of the time the capital market debt is going to be refinanced, which is why we look to the refunding needs chart, as you can see here, and indication of future refinancing needs. On balance, it's more likely that corporates are going to delever via moderating their spending or growing their EBITDA while borrowing less, but there could be some of modest amount of debt repayment as well. Given where rates are today, I'd say, especially on the short-term end of the spectrum, there's not a lot of motivation for corporates to pay down a lot of debt at this point in time. And you can see again on Slide 19 that in the last deleveraging cycle, which was really 2009, 2010, the amount of deleveraging was relatively modest and only lasted for a short period of time. And as you know and I know, equity investors really do expect management teams to manage their balance sheet sufficiently.

Got it. So with the recent blast of investment-grade issuance, we've seen several companies, including your own, start to issue bonds at longer terms, given some of ultra-low interest rates that currently exist. For example, in August, Moody's issued 40-year bonds, I believe, at a 2.55% yield. So have you seen any signs that average bond duration is increasing such that it would start to meaningfully spread out the refinancing pipeline that you spoke to?

Yes, yes. This is something that we have been watching quite closely, and we've seen several issuances of longer duration. That said, this is still on the margin and more focused on the investment-grade part of the corporate issuance. But one driver that wasn't the initial impact of COVID-19 on the markets in March was specifically that spreads widened on shorter duration at that time to a pretty wide extent, and that made longer-dated issuance marginally more attractive at that time. More recently, spreads have obviously compressed, so low rates -- or low effective rates have made it more prohibitive for issuers looking to extend duration. As you noted, Moody's did issue a long duration bond in August, our first one, our inaugural 40-year bond. While extending duration is attractive, I'm just thinking from a CFO's perspective, we have to weigh that against the fact that, currently, rates on the shorter-term date are also quite compelling. And as of last week, I believe the rates in the U.S. 3-year Treasury note was just 16 or 17 basis points and the 5-year note was 26 basis points according to the Department of the Treasury. So still very attractive on the short end. So I'd say maybe for normal -- or for financing of normal course operations, I would expect that many CFOs and treasurers to take advantage of shorter duration issuance. And as you can see here on Slide 17, as for the overall refinancing pipeline, it does remain robust. And there is nearly $3.5 trillion of nonfinancial corporate issuance that is going to mature in North America and Europe over the coming 4 years.

Got it. So besides rising corporate leverage, another long-term tailwind for Ratings revenue has been the disintermediation of banks. Where do we stand regarding that trend? And what impact, if any, has this current recession had on that shift from bank loans to corporate bonds or other rated debt?

As you can see on the screen here on Slide 21, disintermediation, to your point, Patrick, has been a steady trend that we've seen play out over the last 1.5 decades. And it's going to take some time for it to show up in the data to know for sure. But my suspicion is that the current situation is causing a modest short-term headwind to disintermediation. For example, we are seeing less first-time issuance. Our estimate this year is approximately from 550 first-time mandates this year, which is down from the 800 to 900 mandate level we've seen on average over the last couple of years. Many first-time mandates are unsurprisingly speculative grade credits as they are often smaller companies. And those companies really come to the market for a variety of reasons, but it's often to diversify their funding sources and to access potentially lower cost debt. Overall, while spreads have compressed, speculative grade spreads have relatively not recovered to their pre-COVID-19 levels, at least to the same extent that investment grade has recovered. And that's just on data that we've looked at from the St. Louis Fed. I also want to add here that wider spreads fears around speculative grade defaults, lower M&A activity among financial sponsors and bank lenders who have access to cheap capital does create the environment with reduced incentives for first-time mandates to come to the public markets. And I see these factors is a little bit maybe perhaps transitory in nature because the benefits long-term of the public market remain in place. So as the environment continues to improve, first-time issuers should pick up and disintermediation should continue.

And building off of that point. I think a lot of that disintermediation historically has come not just from the shift from bank loans to bonds, but also the syndication of bank loans that Moody's has then able to rate. Obviously, we have seen really strong investment-grade issuance, and to a little bit lesser extent, high yield. But leverage loans have been weak, I think, since March and potentially even a little bit before then. What do you think needs to happen for the leveraged loan market to return to a level of activity we saw in the past few years? And is it as simple as expectations for rates to move higher? I think kind of building off your last answer, may when credit spreads to tighten a little bit. What are you seeing out there right now in the leveraged loan market?

And I think you actually just hit on the key consideration. And it's not just about the overall level of rates, but the expectation for where rates are going. If I try to put then in the context of my answer, with the policy statements that have come out recently from the U.S. Federal Reserve, the current expectation for global GDP growth and the muted expectations for inflation, I would say then current expectations appear to be reflecting a lower for longer scenario. And then as a result, there has been less demand from investors for floating rate debt. And investor preference at this point is for fixed rate debt that has helped certainly bond spreads recover to a greater extent. And that's also, by the way, incentivized issuers towards fixed rate issuance. And it has reduced leverage loan issuance, which is traditionally, as everybody knows, floating rate base. My one watch out here is that concerns around ongoing defaults may have also played a part in the relatively wider spreads, but we have seen levered companies able to access financing. So in some ways, you can almost think about leverage as possibly being a secondary factor in terms of more recent preference for bond versus loans. And then just thinking forward, aside from rate expectations, an uptick in M&A could be beneficial for loan issuance as financial sponsors and some corporates prefer to use loans for M&A financing, given the greater flexibility they'll have around that refinancing avenue, given there are no prepayment penalties and certain covenant considerations.

Got it. Interesting. So moving on to another long-term tailwind for Moody's. I would kind of point to the globalization of debt capital markets and various markets opening up to global capital. The biggest opportunity on that front, I think most will probably say, is China. What has to happen for Ratings in China to become a material financial contributor to Moody's, both in terms of the marketplace itself as well as your business model within that market?

Yes. As you can see on Slide #30, this is clearly a large opportunity, given the size of the Chinese debt market and the pace of growth. We hold a 30% stake in the CCXI. And we've had strong success with our partnership. CSXI is one of the largest domestic rating agencies in China with over 1,700 rated credits. In 2019, we received $70 million in actually attributable income from this joint venture. We already have a strong position in the cross-border market with over 400 rated credits, and that translates to roughly a 38-ish-percent share of the nearly $300 million market in 2019. We also have a very active MA business in Mainland China, and that combines, given in our cross-border business, did result in almost $180 million in revenue for 2019. We also invested last year in a Syntao Green Finance, which is data and analytics on Chinese ESG corporations. And in terms of incremental opportunity, to your question, credit investors are relying on Moody's opinions and analysis. And so we believe Moody's can be very helpful to Chinese companies and the economy in creating the conditions that are necessary for additional foreign investment. The current estimates are that only 2-ish-percent of the Chinese domestic corporate debt is actually owned by investors outside of China. Though certainly, many international investors are interested in investing in China and in their debt capital markets. And while I noted our strength earlier, in the cross-border market, we also have a relationship with many of the large corporates in China and have helped many international investors evaluate those issuers their credits. And I think the way I'd like to sort of end the answer to your question here is, it's most important that we want to participate in a way that is constructive and supportive of the People's Bank of China and their financial markets policy goals in China or for China.

Got it. And then speaking of opening up international markets, I'm curious, where do things currently stand with India? Moody's secured a majority ownership stake in that business in 2014. But we do seem to hear a lot more about China than India these days. So I'm kind of curious what you guys are seeing and hearing with India.

Yes. Longer term, the opportunity remains attractive for us, and but near term, there certainly have been some challenges. Even before the spread of that COVID, India's economic growth had been decelerating, i.e., private investment remains flat, exports have slowed, household consumption remained relatively weak. With the spread of COVID, the Indian government announced and then extended various lockdown measures. That has further dampened growth in the near term. I'd say that given slowing GDP growth and adverse market statement, the bond market has remained sluggish since 2019, which has been impacting -- which has impacted, obviously, our CRISA results. I did see recently the Indian authorities announced additional fiscal and monetary stimulus in the amount of around 10% of their GDP. And our MIS research is projecting -- even considering that a contraction of around 3% of the economy this year, followed by a significant, call it, 7% real GDP rebound in 2021. And that's part of our August 2020 update. Regarding ECRIS specifically, there have been some management changes, which we expect will help drive growth going forward. The ECRI Board did appoint a new President of Ratings in July and a new CEO in August. And both of these new executives have very strong track records. And each has more than 30 years of experience in banking and finance. And we're expecting that they will help strengthen the ECRIS analytical capabilities as well as thought leadership and certainly in help -- certainly will help manage relationships with some of ICRA's key stakeholders.

So shifting back to the U.S. now. As you think about the upcoming election, does Moody's see any incremental regulatory risks ahead if there's a change in administration? And this is just me speaking. But my view is that, depending on who a Biden administration will put as the head of the Treasury Department or the head of SEC, there could be an elevated risk for them to review the issuer pays business model. But how are you guys currently viewing the upcoming election?