EDWARD I.

ALTMAN,l JOHN HARTZELU and MATTHEW PECK 2

'New York University, 2Sa/omon Brothers Inc

15. Emerging market corporate bonds - a scoring

system

ABSTRACT

In this article we discuss a scoring system (EMS model) for emerging markets corporate
bonds. The scoring system provides an empirically based tool for the investor to use in
making relative value determinations. The EMS model is an enhanced version of the
statistically proven Z-score model (Altman, 1968) designed for US companies. Unlike the
original Z-score model, our approach can be applied to non-manufacturing companies and
manufacturers, and is relevant for privately held and publicly owned firms. The adjusted
EMS model incorporates the particular credit characteristics of emerging markets compa-
nies, and is best suited for assessing relative value among emerging markets credits. The
EMS model combines fundamental credit analysis and rigorous benchmarks together with
analyst-enhanced assessments to reach a modified rating, which can then be compared with
agency ratings (if any) and market levels. We have included a summary of Mexican
companies for which we have applied the EMS model.

The emerging market scoring model (EMS model) for rating emerging markets
credits is based first on a fundamental financial review derived from a quantita-
tive risk model and second, by analyst assessments of specific credit risks in
order to arrive at a final analyst modified rating. This rating can then be
utilized by the investor, after considering the appropriate sovereign yield spread,
to assess equivalent bond ratings and intrinsic values. The foundation of the
EMS model is an enhancement of Altman's Z-score model, described in the
body of this report, resulting in an EM score and its associated bond rating
equivalent.
The EM score's rating equivalent is then modified based on four critical
factors including: the firm's vulnerability to currency devaluation, its industry
affiliation, its competitive position in the industry and its market to book
equity value. Unique features of the specific bond issue should also be consid-
ered. These modifications are an important complement to the EM score.
The resulting analyst modified rating is compared to the actual bond rating
(if any). Where no agency rating exists, our modified analyst rating is a means
to assess credit quality and relative value both to credits within a country and
to US corporates. These results are listed in Table 1 for Mexican corporates
based on year-end 1994. The results have since been updated as of mid-1996
financials. The implied yield spread based on the analyst modified rating can
be observed from the US Corporate bond market. Steps 1-7 outline the process
391
R. Levich (ed.), Emerging Markee Capital Flows, 391-400.
I© 1998 Kluwer Academic Publishers.
Table 1. Mexican corporate issuers - EM scores and modified ratings based on end 1994 w
1.0
tv
EM Bond-rating Modified Ratings
Company Industry score equivalent rating M/S&P/D&P
tTl
~
Aeromexico Airlines -4.42 D D NR/NR/NR ~
Apasco Cement 8.48 AAA A Ba2/NR/NR -~
CCM Supermarkets 4.78 BB- B+ NR/NR/NR s::.
Cemex Cement 5.67 BBB- BBB- Ba3/BB/BB ;:s
Cydsa Chemicals 4.67 BB- B+ NR/NR/NR ~
DESC Conglomerate 4.23 B BB+ NR/NR/NR s::.
:--
Empresas ICA Construction 5.96 BBB BB Bl/BB-/B+
Femsa Bottling 6.37 A- BBB+ NR/NR/NR
Gemex Bottling 5.40 BB+ BB+ Ba3/NR/NR
GIDUSA (Durango) Paper and forest products 4.61 B+ BB Bl/BB-/NR
GMD Construction 4.85 BB B- B3/NR/NR
Gruma Food processing 5.56 BBB- BBB+ NR/NR/NR
Grupo Dina Auto manufacturing 5.54 BBB- BB+ NR/NR/B
Hylsamex Steel 5.51 BBB- BB- NR/NR/NR
IMSA Steel 5.45 BBB- BB- NR/NR/NR
Kimberly-Clark de Mexico Paper and forest products 8.96 AAA AA NR/NR/NR
Liverpool Retail 9.85 AAA A+ NR/NR/NR
Moderna Conglomerate 5.28 BB+ BB+ NR/NR/NR
Ponderosa Paper and forest prod ucts 6.64 A BB NR/NR/NR
San Luis Autoparts 2.69 CCC CCC- NR/NR/NR
Sidek Conglomerate 4.68 BB- B NR/NR/CCC
Simec Steel 4.42 B+ B- NR/NR/CCC
Situr Hotel and tourism 5.17 BB+ B NR/NR/CCC
Synkro Textile/apparel 1.59 CCC- CCC NR/NR/NR
TAMSA Steel pipes 3.34 CCC+ B NR/NR/NR
TELMEX Telecommunications 9.57 AAA AA- NR/NR/NR
Televisa Cable and media 7.29 AA BBB+ Ba2/NR/NR
TMM Shipping 5.34 BB+ BB+ Ba2/BB-/NR
Vitro Glass 5.18 BB+ BB Ba2/NR/NR

NR: No rating. M: Moody's. S&P: Standard and Poor's. D&P: Duff and Phelps. Note: Ratings are for senior long-term foreign debt unless otherwise specified.
EM scores were calculated using fiscal year end 1994 financials.
Source: Salomon Brothers Inc.
 Emerging market corporate bonds - a scoring system 393

by which we use the EM score to reach an analyst modified rating. Note that
our analyst modified rating is not constrained in any manner by the so-called
'sovereign-ceiling'. We do advocate, however, factoring in the appropriate cur-
rent sovereign yield spread differential between the emerging market country
and comparable duration US Treasuries (Step 7). In most cases, the full
sovereign 'haircut' should be added to the stand-alone issuer spread. There are
instances, however, where the full sovereign spread is not appropriate because
of unique attributes of the issuer or the issuer's sovereign affiliation. For
example, investor portfolio considerations may swell the demand for a firm in
a key industry, such as telecommunications. Or, the sovereign's huge supply of
outstanding debt relative to investor demand may widen that security's spread
vis-a-vis a more modest supply of a particularly attractive corporate bond. The
resulting spread may indeed be below that of the sovereign as a result of
technical factors rather than fundamental credit characteristics.

STEP I - US BOND RATING EQUIVALENT

Score each bond by its EM score and classify it relative to its stand-alone US
bond rating equivalent. Emerging market corporate credits should initially be
analyzed in a manner similar to traditional analysis of US corporates. This
involves the examination of measures of performance in such a manner as to
establish a rating equivalent of the particular issuer. Instead of using a new
ad hoc system, which may not be based on a rigorous analytical examination
of credit worthiness, we will use an established and well-tested system. Since it
is not yet possible to build such a model from a sample of emerging market
credits, we suggest testing the applicability of a modified version of the original
Z-score model. It is based on a comparative profile of bankrupt and non-
bankrupt US manufacturers, however, our modification can be applied to non-
manufacturing, industrial firms and for private and public entities.
The original Z-score model is based on at least two data sources that make
it difficult to use for all emerging markets corporates: it requires the firm to
have publicly traded equity and it is primarily for manufacturers. In more than
25 years of experience in building, testing and using credit scoring models for
a variety of purposes, the original model has been enhanced to make it applica-
ble for private companies and non-manufacturers. The resulting model, which
is the foundation for our EMS model approach, is of the form:

EM score = 6.56(Xd + 3.26(X2 ) + 6.72(X3) + l.05(X4 ) + 3.25

where Xl = working capital/total assets, X2 = retained earnings/total assets,
X3 = operating income/total assets, X4 = book value equity/total liabilities.
The constant term in the model (3.25) enables us to standardize the analysis
so that a default equivalent rating (D) is consistent with a score of zero or below.
394 E.1. Altman et al.

Table 2. Average EM-score variables by bond rating - US industrials 1994

(Xl) (X 2 ) (X4 )
working retained (X3 ) stockholders
Bond Capital/ earnings/ oper. income/ equity/
rating total assets total assets total assets total liabilities

AAA 0.175 0.470 0.187 1.120

AA+* 0.150 0.450 0.166 1.085
AA- 0.142 0.439 0.150 1.025
A+ 0.138 0.359 0.114 0.970
A 0.127 0.350 0.107 0.866
A- 0.120 0.276 0.099 0.755
BBB+ 0.114 0.226 0.088 0.701
BBB 0.103 0.184 0.080 0.636
BBB- 0.081 0.065 0.075 0.546
BB+ 0.065 0.040 0.070 0.444
BB 0.060 (0.031) 0.065 0.328
BB- 0.055 (0.040) 0.062 0.305
B+ 0.050 (0.091 ) 0.055 0.287
B 0.040 (0.149) 0.050 0.272
B- 0.025 (0.200) 0.045 0.169
CCC+ 0.010 (0.307) 0.025 (0.052)
ccc (0.044) (0.321 ) O.ot5 (0.099)
CCC- (0.052) (0.561 ) (0.025) (0.256)
D (0.068) (0.716) (0.045) (0.325)

* There were insufficient data points to calculate the average AA + ratio.

Source: In-Depth Data Corp. Results are based on over 750 US industrial corporates with rated
bonds outstanding; 1994 data.

Major accounting differences between the emerging market country and the
United States must be factored into the data used in the calculations of our
measures. For example, our calculation of retained earnings is based on the
sum of retained earnings and capital reserve, the surplus (deficiency) on restate-
ment of assets, and the net income (loss) for the current period.
The model has been tested on samples of both non-manufacturers and
manufacturers in the US and its accuracy and reliability have remained high.
We have also carefully calibrated the variables and the resulting score with US
bond rating equivalents. These equivalents (Tables 2 and 3) are based a sample
of more than 750 US firms with rated bonds outstanding.

Step 2 - adjusted bond ratingfor forex devaluation vulnerability

Each bond is analyzed as to the issuing firm's vulnerability to problems in

servicing its foreign currency denominated debt. Vulnerability is assessed based
on the relationship between non-local currency revenues minus costs compared
to non-local currency interest expense, and non-local currency revenues versus
non-local currency debt. Finally, the level of cash is compared with the debt
coming due in the next year.
 Emerging market corporate bonds - a scoring system 395

Table 3. US bond rating equivalent based on EM score

US Average Sample
equivalent rating EM score size

AAA 8.15 8
AA+ 7.60
AA 7.30 18
AA- 7.00 15
A+ 6.85 24
A 6.65 42
A- 6.40 38
BBB+ 6.25 38
BBB 5.85 59
BBB- 5.65 52
BB+ 5.25 34
BB 4.95 25
BB- 4.75 65
B+ 4.50 78
B 4.15 115
B- 3.75 95
CCC+ 3.20 23
CCC 2.50 10
CCC- 1.75 6
D 0.00 14

Source: In-Depth Data Corp. Average based on over 750 US industrial corporates with rated debt
outstanding; 1994 data.

If the firm has high (weak) vulnerability, that is, low or zero non-local
currency revenues and/or low or zero revenues/debt, and/or a substantial
amount of foreign currency debt coming due with little cash liquidity, then the
bond rating equivalent in Step 1 is lowered by a full rating class, such as, BB +
to B +. There is no upgrade for a low (strong) vulnerability and we apply a
one notch (BB + to BB) reduction for a neutral vulnerability assessment.

STEP 3- ADJUSTED FOR INDUSTRY

The original (Step 1) bond rating equivalent is compared to a generic industry

safety rating equivalent (Table 4). We utilize the Salomon Brothers Inc's
industries' ratings. For up to each full letter grade difference between the two
ratings, Step 2's bond rating equivalent is adjusted up or down by one notch.
For example, if the rating from Step 1 is BBB and the industry's rating is
BBB -, BB +, or BB, then the adjustment is one notch down; if the difference
is more than one full rating class but less than two full ratings, there is a two-
notch adjustment, and so on. Finally, the industry environment in the specific
emerging market country is factored into the analysis.
396 E.1. Altman et al.

Table 4. Average credit safety of industry groups - Salomon Brothers

Average sector credit safety

Telecommunication High A
Independent finance High A
Natural gas utilities High A
Beverages High A
High quality electric utilities High A
Railroads High A
Food processing Mid A
Bottling Mid A
Domestic bank holding Low A
Tobacco Low A
Medium-quality electric utilities Low A
Consumer products industry Low A
H.G. diversified Mfg./conglomerate Low A
Leasing Low A
Auto manufacturers Low A
Chemicals Low A
Energy Low A
Natural gas pipelines High BBB
Paper/forest products Mid BBB
Retail Mid BBB
P&C insurance Mid BBB
Aerospace/defense Mid BBB
Information/data technology Mid BBB
Supermarkets High BB
Cable and media High BB
Vehicle parts High BB
Textile apparel High BB
Low-quality electric utilities MidBB
Gaming Mid BB
Restaurants MidBB
Construction MidBB
Hotel/leisure MidBB
Low quality manufacturing MidBB
Airlines Low BB
Metals High B

Source: Adapted from six-month credit quality overview, Salomon Brother Inc., January 18, 1995.

STEP 4- ADJUSTED FOR COMPETITIVE POSITION

Step 3's rating is adjusted up (or down) one notch if the firm is a dominant
(or not) company in its industry or if it is a domestic power in terms of size,
political influence and quality of management. It is possible that the consensus
competitive position result is neutral (no change in rating).
 Emerging market corporate bonds - a scoring system 397

STEP 5- EQUITY MARKET VALUE CONSIDERATION AND IMPACT

From time to time we consider modifying the system to consider other impor-
tant factors. One such ingredient that we now feel is relevant to evaluating the
credit risk of a company is the market to book value of the firm's equity.
Despite the inefficiencies in emerging markets equity valuations, a company
whose stock is valued highly by the financial community can usually borrow
more easily and raise new equity or sell assets at better prices than one which
is being discounted by investors. Since the corporate bonds of emerging market
companies are, by rating agency definitions, almost all non-investment grade,
their yield and volatility patterns at times are more correlated with equity
market activity than are investment grade corporates.
There are two ways that we can introduce a market value of equity factor
into our system. First, a new variable reflecting the market to book value of
equity, or some similar measure, could be added to the existing four variables.
Since the original data base used to construct the EM system did not contain
that variable, it is impractical to re-estimate the equation using a new data
base. The second approach is to add an additional phase to our modified
equivalent bond rating process - one that incorporates a comparison of the
bond rating equivalent using the book value of equity to total liabilities (X4 in
the model) versus the same variable with the market value of equity (number
of shares outstanding times the stock price) substituted for the book value.
This second approach is what we actually have done. The procedure we
followed is to calculate the bond rating equivalent in the traditional manner,
which involves the initial bond rating based on the multi-variate model, and
modifications based on currency devaluation vulnerability, industry affiliation
and competitive position. The final phase now is to compare the bond rating
equivalent using book equity to the rating equivalent using the market value
of equity.
If the two systems give the identical rating or are different by only one
notch, then the modified rating is unchanged. If, however, the two versions
result in a two-notch differential, then we increase or decrease the final modified
rating by one notch. Finally, if the difference is a full rating class (three notches)
or more, the modified rating is changed by two notches.
We first applied this further modification in 1996. Based on six months
ended June 1996 data, 17 of 38 Mexican firms had higher bond rating equiva-
lents when using the market value compared to the book value equity. Of the
17 firms, six had the same modified rating since the difference was one notch;
one had a one notch upgrade and 10 had a two notch upgrade. Seven firms in
total had lower EM scores using market value compared to book value of
equity, with five resulting in a one-notch downgrade and the other two not
changed. Fourteen firms had the identical rating using the book and market
value of equity measures.
The impact of using the market value of equity versus the book value can
have a major impact in the final modified rating for a company. Such an
398 E.1. Altman et al.

impact reflects the often inefficient market for Mexican companies' equity. The
volatility of the Mexican peso and its impact of the Mexican equity market
can mask the intrinsic values of Mexican equities. In addition, inflation account-
ing can distort the book value of equity of Mexican firms because of income
statement non-cash charges and the consequent changes in retained earnings
and stockholders equity. We believe that despite these inefficiencies, the
Mexican equity market has rallied sufficiently to begin to incorporate the
market equity value in our model.

STEP 6- SPECIAL DEBT ISSUE FEATURES

If the particular debt issue has unique features, such as collateral, a bona fide,
high-quality guarantor, or a restricted cash trust to payoff bondholders, then
the issue should be upgraded accordingly.

STEP 7- COMPARISON TO THE SOVEREIGN SPREAD

The analyst modified rating is then compared to what US corporate bonds of

the same rating are currently selling for. The US corporate credit quality spread
is then added to the appropriate option adjusted spread of the sovereign bond.

How TO USE THE EMS MODEL

Unique features of the EMS model

An important distinction must be made between this model and the original
Z-score model. First, this model, referred to by Altman (1993)1 as the Z"-score
model, is applicable for non-manufacturers and private firms in addition to
manufacturers and public firms. Second, the model applies our analysts' sub-
jective measures of credit strength as outlined in Steps 2-4, and the relationship
between the equity value based on market prices vs. book values.
It is important to remember that the stand-alone rating generated in Step 1
is based on the specific operating performance and financial characteristics of
the company. The analyst modified rating likely will change with the operating
environment within which a company functions. For US firms in mature
industries, this environment does not typically change dramatically. For
Mexican firms, however, their respective operating environments are subject
to major changes, such as the peso crisis of December 1994. Outlined below

1 See E. Altman, Corporate Financial Distress and Bankruptcy, 2nd edition, John Wiley & Sons.
N.Y., 1993, Chapter 8.
 Emerging market corporate bonds - a scoring system 399

are some of the unique characteristics of the operating environments for

Mexican firms.

Foreign exchange risk

One of the largest credit risks facing Mexican Eurobond issuers at this time is
their non-local currency debt service capacity. Two critical factors affecting a
firm's debt service capacity are their export revenues and non-peso cost struc-
ture. The extraordinary political and economic events of 1994-95 undoubtedly
raised the default risk of Mexican companies. Firms with low export revenues
became particularly vulnerable to exchange risk, given their dollar liabilities
and associated debt service. In addition, those firms with a high percentage of
raw materials sources from abroad have experienced reduced margins and debt
service capacity.

Accounting anomalies
The high inflation environment in Mexico precludes Mexican firms from the
standard credit analysis applied to US companies (the original Z-score model
was for US companies only). For example, the impact of noncash foreign
exchange losses on pre-tax earnings is dramatic for Mexican firms. Analysis of
retained earnings and the book equity, and therefore leverage ratios of Mexican
firms, is subject to more careful analysis and appropriate adjustments.

Government intervention
The Mexican Government has recently pro-actively supported certain sectors
of the Mexican economy in order to prevent default. Examples of this include
the support of the banking system through programs like Procapte; the facilita-
tion of providing short-term financing for Grupo Sidek (the Mexican conglom-
erate which defaulted, and subsequently made payment, on its commercial
paper); and the government's renegotiation of construction sector concessions.
Despite its recent support of the private sector, the Mexican Government's
continuing presence in crisis situations cannot be assumed with certainty.

Bank financing environment

Short-term financing became prohibitively expensive in Mexico in 1995. Interest
rates for short-term financing soared to above 80% and cetes rates to the 60%
level. Many Mexican firms could not economically access short-term capital.
Historically, Mexican firms maintained high levels of short-term liabilities to
finance working capital, in part, because longer-term financing was unavailable
given Mexico's high inflation rate. The current government support of the
banking system has enabled many banks to avoid liquidity problems since the
devaluation. However, the Government's continuing support of the banking
system in the future, while highly likely, cannot be guaranteed.

Market share dominance

Most of the Mexican Eurobond issuers represent the largest of Mexican compa-
nies. Most of these companies were either owned by the Government prior to
400 E.1. Altman et al.

the late 1980s and subsequently privatized, or they were controlled by wealthy
families for decades. Therefore, most Mexican Eurobond issuers have typically
dominated their respective markets. With the advent of NAFTA, and the
economic weakness brought about since the devaluation, we expect Mexican
firms will see greater competition and shrinking market shares in the future.
Our analyst modified rating embodies these particular Mexican credit fea-
tures. Together with timely sovereign and economic research, we can adjust
the analyst modified rating to incorporate changes in the Mexican economic
and corporate landscape.
Applying the analyst modified rating to the current market

The analyst modified rating (Table 1) should be used to evaluate whether

current market levels for bonds appropriately reflect the credit risk implied by
the rating. Since the devaluation, the Mexican corporate market has traded
with extreme volatility. Market levels have often been driven by technical
factors (more sellers than buyers) rather than fundamental credit-worthiness.
The analyst modified rating should be used to provide a clear measure of
relative credit risk independent of market technicals.
The EMS model is not a bankruptcy predictor

The EMS model is not a predictor of emerging markets company bankruptcy

for two reasons. First, when we constructed the model, the current issuers of
Mexican Eurobonds had not experienced defaults on their dollar Eurobond
liabilities (nearly all of the Eurobonds have been issued within the last five
years). It should be noted that in the subsequent 2 years, four Mexican issuers
defaulted and our EM score model had given all four companies' bonds either
a CCC- or D rating prior to default. 2 Second, the unique characteristics of
the Mexican political and economic environment make bankruptcy prediction
more difficult than it is for US firms. The Mexican Government's potential
involvement in the corporate restructuring process is a variable which cannot
be reasonably built into the model. Our model is a means to estimate equivalent
bond ratings and intrinsic fixed income values.

CONCLUSION

The EMS model should be used to assess relative value among credits in the
inefficient trading environment for emerging markets credits. The model is
flexible, allowing for future modifications depending on the operating and
financial environment and sovereign risk. Early empirical results indicate that
the model has been extremely accurate and continued testing and use would
seem to be a reasonable conclusion.

2The four Mexican defaults involved Grupo Synkro, Situr, Sidek and GMD. The first three
defaulted in 1996 and the latter in 1997.