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It’s better to provide too much credit information

As the Facade and Blind Spot grow smaller through self-disclosure and providing feedback, the Arena expands.With mutual disclosure, the Unknown area shrinks as well. The goal of positive communication is to expand the Arena by learning more about yourself from others’perspectives and sharing more information that may be unknown to others. In this way,more information is passed back and forth between you—creating new opportunities for synergy and creativity. The second tool is the Self-Disclosure Checklist (Exercise 1). We typically don’t give much thought to how well we self-disclose information to others. The Self-Disclosure Checklist provides you with an opportunity to reflect on how well you do this vital activity. The more honestly you can answer the questions, the more insights you will have into your ability to self-disclose information about yourself.

If you answer yes to three or more of the questions in the checklist, you may want to think about how freely you disclose information about yourself. While it isn’t appropriate to share everything about your life, self-disclosure is essential in a partnership. The greater the self-disclosure, the more information flows and the more trust is established. It’s better to provide too much information about yourself than not enough.

Spread that solely mirrors credit risk

Based on historical data on defaults we can derive the fraction of the spread over riskless bonds for different rating classes and maturities, that is solely due to the probability of default and loss given default. The expected loss rate is derived from these two factors. Market participants who have a buy-and-hold perspective must decide on whether the current spread of a corporate bond sufficiently compensates for default and migration risk.

This is rather the perspective of a private than an institutional investor, because the latter in general has a short- to medium-term investment horizon and rarely holds a bond to maturity. In general, the institutional investor tries to achieve an excess return against a benchmark with a trading oriented management approach.

However, for the calculation of the required spread from a buy-and-hold perspective reliable default probabilities and recovery rates have to be used. If the issuer has an agency rating, Moody’s historical database is a good starting point. This database compiles expected default probabilities on a historical basis which is updated annually and also average recovery rates depending on the seniority of a bond. Those values allow to calculate a “fair” spread that solely mirrors credit risk.

Spread differentials between issuers with similar credit quality

One typical reason for spread differentials between bonds of the same rating are liquidity considerations, particularly with respect to stress situations. Generally, bonds with a large issue size, issued recently and actively traded by several market makers tend to be the most liquid. Sometimes old bonds with a small issue size, too, trade at rather tight levels. This is often the case for typical “CDO (Collateralized debt obligations) names”, that is bonds that are often included when CDOs are set up. Another reason for wide spread differentials between issuers with similar credit quality is that many market participants are concerned with potential mark-to-market losses. Therefore, rather illiquid and more volatile bonds require a higher spread, even if spread volatility is rather due to market technicals than uncertainty regarding company fundamentals. Consequently, it is natural that credit spreads differ even for bonds and issuers with the same rating.

But more importantly, only a fraction of the actual credit spread is explained by credit risk, which in turn is reflected by the rating.

Possible dangers and risk associated with loans

One example from the automotive sector is the large spread differential between Ford and Renault bonds with similar coupon and maturity. Although the rating agencies assign approximately the same credit risk to both issuers, investors view the risk that is related to owning Ford bonds as significantly higher. Our study clearly outlines that Ford bonds have been much more volatile than Renault bonds between September 2003 and February 2004. When S&P put Ford on credit watch negative on October 21, 2003, spreads widened massively. Even if only very few investors feared a multiple notch downgrade of Ford from the then BBB rating, a 1 notch downgrade to BBB coupled with a negative outlook would have caused concerns about a later downgrade of Ford into high-yield. There were fears
that the high-yield market would not be able to absorb the large volume of outstanding Ford bonds, and from a fundamental perspective that the company’s financing costs would rise, thus limiting the company’s financial flexibility massively. This example highlights that market technicals at least temporarily can be the dominant driver of credit spreads.

The wide dispersion of credit spreads

Ratings are designed to reflect credit risk over time. Two bonds from different issuers that share the major characteristics, for example with respect to the degree of structural and legal subordination, coupon and embedded optionality, and additionally have the same rating, should trade approximately at the same level. Bond spreads of course also depend on maturity, yielding a term structure of credit spreads. The average spread of an issuer within a particular rating class furthermore depends on the liquidity of the individual bonds and its sector classification.

Despite the wide dispersion of credit spreads within the rating buckets the general link between credit spreads and ratings is clear, with average spread increasing as credit quality decreases. However, as our study illustrates there are large overlaps between individual rating distributions. Myriad examples can be found to show that market participants often perceive the risk of one company in comparison to another to be completely different, even if both have the same rating. It should be noted that our sturdy includes bonds with rather different maturities and coupons.
Altman (1989) and Taylor and Perraudin (2001) have shown the presence of highly persistent inconsistencies between credit ratings and bond spreads, even after adjusting for liquidity and potential tax effects.

The credit lesson for competitors

Coca-Cola introduced new Coke after taste tests proved it more popular than Pepsi and the original Coke. However, the launch of new Coke contained an untested assumption: that flavour mattered more than image. The information gathered built upon this flawed notion, confirming the decision that classic Coke needed to be replaced. This view was contrary to what customers – past, present and future – actually wanted. Interestingly, this goodwill was so powerful that the cause of the company’s failure was also the source of its salvation, as consumers forgave Coca- Cola and realised that they appreciated classic Coke, or else tried it for the first time.

Don’t react emotionally to your credit

Technically, the launch went well. However, even before they had tasted it millions of Americans disliked new Coke. Across the country and especially in the South, the birthplace of Coca-Cola, consumers reacted angrily and emotionally to the new formula. Thousands contacted the organisation’s headquarters in Atlanta. Remarkably, many were not Coca-Cola drinkers, simply American consumers disappointed at a major change to an iconic American product.

By mid-July, the pressure had become enormous, and Roberto Goizueta, the chairman, together with other senior executives announced that classic Coke would return. The news was leaked the previous day, and ABC News had interrupted daytime programming to break the story. The next morning headlines were filled with what insiders called “The Second Coming”. On the day of the official announcement, Coca-Cola’s hotline recorded 18,000 calls. For the first time in over two months people were positive, glad that their voices had been heard and that such a change had been aborted.

The company’s executives might have feared the consequences of reintroducing classic Coke, resulting as it did from unhappy customers, bad press and ignominious defeat. But the opposite occurred: it proved massively popular. Against all expectations, classic Coke outsold new Coke, and sales overtook Pepsi early in 1986.

Attempting to explain the renewed popularity of classic Coke, senior executives told the Wall Street Journal: It’s kind of like the fellow who’s been married to the same woman for 35 years and really didn’t pay much attention to her until somebody started to flirt with her.

How great companies deal with credit - the cola wars

In 1975, Pepsi directly targeted its long-term competitor, Coca-Cola, with the “Pepsi Challenge”, claiming that in taste tests people preferred Pepsi. After Coca-Cola conducted its own tests rumours spread that Coke did indeed have a taste problem.

In public, Coca-Cola appeared unconcerned. But senior executives knew that they could not afford to ignore Pepsi’s latest marketing offensive, given that Coke’s market share had fallen substantially in the face of competition from Pepsi and from new beverages such as diet drinks, citrus flavours and caffeine-free colas. Indeed, Coca-Cola, realising that tastes were changing and competition was getting tougher, was itself marketing many of these new products. However, Coca-Cola’s taste problem was a serious issue for a core product, and Coke’s shrinking lead in the cola market convinced senior executives of the need to act. In the New York Times, Brian Dyson, head of Coca-Cola USA, commented:  There is a danger when a company is doing as well as we are … to think that we can do no wrong. I keep telling the organisation, we can do wrong and we can do wrong big.

During December 1984 the company decided to proceed with a new formula for Coke. The target date for the launch of the new formula, new Coke, was April 1985 and Dyson involved Coca-Cola’s senior marketing and public relations officials, who were given the vital (and secret) task of co-ordinating new Coke’s debut.

Exert direct control over your credit

Businesses generally either dwell on their competitors’ activities or ignore them on the grounds that they are unable to exert any direct control. The amount of attention that needs to be paid to competitors varies according to the nature of the industry and market, and usually lies between these two extremes. Decision-makers may be guided by an
overall vision and specific objectives, but competitive pressures can also be decisive in determining their decisions.

The impact of competition Michael Porter has identified five forces affecting competition in an industry, and these provide an interesting lens through which to view current and potential competitors. The five forces are industry rivalry, market entry, substitutability, suppliers and customers.

Industry rivalry Companies in the same industry – be it banking, car manufacturing, travel and tourism, retailing or whatever – are the most obvious and prominent source of competition. The cola wars fought by Pepsi and Coca-Cola are just one example of this.

Credit holds a great deal of promise

Although mergers hold a great deal of promise and there are undoubted successes, it seems that negotiating the many pitfalls inherent in such deals – from cultural issues to communications – can be hazardous and difficult. This may not be the fault of the merger; the forces that drive firms to merge in the first place might also place strains on the union over the long term.

After a painful birth, DaimlerChrysler now has strong positions in many markets,opportunities for growth in new ones and a pool of valuable resources, including some of the strongest brand names in the automotive sector. Leaders able to engineer the merger process competently in the future will have a skill that is in great demand and short supply.