July 28, 2005

Link found between high-paid executives and credit risk

NEW YORK

Investors may want to take a hard look at stock options and bonuses for top executives before investing in a company’s bonds.

Corporations doling out super-sized incentive compensation packages to chief executives appear to face a greater risk of a debt default or significant downgrade, a study by Moody’s Investors Service suggests.

The report, described as the first empirical examination of a link between excessive compensation and credit risk, may provide new ammunition to a growing chorus of critics attacking escalating pay packages.

The study ‘‘is confirming that there is a relationship between high pay and extra risk for the company,’’ said Christopher Mann, a Moody’s senior vice-president and author of the report.

‘‘It’s been seen in other ways, and now we are showing that for the debt markets it’s apparently a significant factor.’’

While routine variations in salaries do not appear to predict credit risk, large and unexplained bonuses and option awards are correlated with defaults and large rating downgrades, the firm said in the report.

Moody’s studied bond ratings and defaults for companies from 1993 to 2003, and found that of 43 companies that defaulted, 22 had offered their CEOs much larger than expected bonuses or stock option grants, or both, at least once.

Of the 214 companies that experienced sharp downgrades, CEO compensation was higher than expected in 140 cases.

As it turns out, the most infamous collapse in recent years landed on Moody’s excessive-compensation roster. Enron Corp. made the list in six of the seven years before its bankruptcy.It was the failure of credit agencies to detect problems at Enron that, in part, led both Moody’s and Standard & Poor’s, the other big bond rating agency, to beef up their governance analysis.

Moody’s cautioned that not every company with unusually large compensation is a high risk. And its analysts couldn’t conclude that high equity awards and cash bonuses were themselves a cause of the poor bond showing.

The firm dipped into previous research to provide possible explanations for the results.

For example, Moody’s speculated, compensation that is out of line may indicate that board oversight is lax and management faces insufficient pressure to deliver good performance.

It also said compensation that is highly sensitive to immediate financial performance may create incentives for CEOs to manipulate short-term performance at the expense of longer-term creditworthiness.

Associated Press

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