6-Credit Rating & Bonds

7/25/2019 6-Credit Rating & Bonds

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Credit Rating & Bonds


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Introduction

Credit is important because individuals and corporations with poorcredit will have difficulty finding financing and most likely will have topay more because of the risk of default.

Credit ratings are a tool used by lenders to determine the types ofloans and rate of interest that can be extended to a potential borrower.

A corporation's credit rating is an assessment of whether it will be able

to meet its obligations to bond holders and other investors. Creditrating systems for corporations generally range from AAA or Aaa atthe high end to D (for default) at the low end.

our credit rating is an independent statistical evaluation of your abilityto repay debt based on your borrowing and repayment history.

!f you always pay your bills on time" you are more likely to have goodcredit and therefore may receive favorable terms on a loan or credit

card such as relatively low finance charges. !f your credit rating is poor because you have paid bills late or have

defaulted on a loan" you may be offered less favorable terms or maybe denied credit altogether.


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Credit Rating Agencies

A company that provides investors withassessments of an investment's risk. #he issuers ofinvestments" especially debt securities" pay creditrating agencies to provide them with ratings.

A high rating indicates low risk and may thereforeencourage investors to buy a security. Additionally"banks may only invest in securities with a high ratingfrom two or more credit rating agencies.

$itch" %& and oody's are the three most

prominent global CAs. #he ratings have letter designations (such as AAA" *"

CC) which represent the +uality of a bond. *ond ratings below ***,*aa are called -unk *onds.


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Credit Rating Agencies

#he ratings given by CAs are only theiropinions/.

#hus" they are not a recommendation to buy"

sell or hold a security and do not address thesuitability of an investment for an investor.egulators have almost fully outsourced/ to

CAs much of the responsibility for assessing

debt risk.$or investors" ratings are a screening tool that

influences the composition of their portfoliosas well as their investment decisions.


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Credit Ratings & Basel 2 Norms

#he *asel 0 norms (ratings1based regulations)are much common in 2%A than across3urope.

egulatory changes in banks4 capital

re+uirements under the *asel 0 norms haveresulted in a new role to credit ratings.#he ma5or ob5ective of *asel 0 is to revise the

rules of the 6788 *asel Capital Accord so as toalign banks4 regulatory capital more closelywith their risks" taking account of progress inthe measurement and management of theserisks and the opportunities which theseprovide for strengthened supervision.


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2nder illar 6 of *asel 0" regulatory capitalre+uirements for credit risk are calculated accordingto 0 alternative approaches91

(6) #he %tandardi:ed Approach ; measurement of credit

risk is based on external credit assessmentsprovided by 3xternal Credit Assessment !nstitutionssuch as credit rating agencies or export creditagencies.

(0) #he !nternal atings1*ased Approach ; sub5ect tothe supervisory approval as to the satisfaction ofcertain conditions" banks use their own ratingsystems to measure some or all of the determinantsof credit risk.


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2nder the $oundation iven Default (=>D) and 3xposure at Default(3AD).


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2nder the regulatory capital re+uirements for operational risk" thereare ? options of progressively greater sophistication91

2nder the *asic !ndicator Approach (*!A)" the capital charge is apercentage (6@) of the banks4 annual gross income

2nder the %tandardi:ed Approach (%A)" the capital charge is the sumof specified percentages of the banks4 annual gross income from

eight business lines (corporate finance168" trading & sales168"retail banking160" commercial banking16@" payment & settlement168" agency services16@" asset management160 and retailbrokerage160) or alternatively from two of these business lines(retail & commercial banking)

2nder the Advanced easurement Approach (AA)" sub5ect to thesatisfaction of more stringent supervisory criteria" banks estimate the

re+uired capital with their own internal systems for measuringoperational risk

illars 0 & ? of *asel 0 are concerned with supervisory review ofcapital ade+uacy & the achievement of market discipline throughdisclosure


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Procedures & Methods of CRAs

#he processes and methods used to establish creditratings vary widely among CAs

#raditionally" CAs have relied on a process based on a+ualitative and +uantitative assessment reviewed andfinali:ed by a rating committee

ecently" there has been increased reliance on+uantitative statistical models based on publicly availabledata

Bo single model outperforms all the others as theperformance is heavily influenced by events

#he key measure in credit risk models is the measure ofthe robability of Default (D) but exposure is alsodetermined by the expected timing of default and by theecovery ate (3) after the default has occurred


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%tandard & oor4s ratings seek to capture only theforward1looking probability of the occurrence ofdefault. #hey provide no assessment of the expectedtime of default or mode of default resolution andrecovery values

oody4s ratings focus on the 3xpected =oss (3=)which is a function of both D and 3

$itch4s ratings also focus on both D and 3. #heyhave a more explicitly hybrid character in that analystsare also reminded to be forward1looking and to be

alert to possible discontinuities between past trackrecords and future trends #he credit ratings of oody4s and %tandard & oor4s

are assigned by rating committees and not byindividual analysts


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CAs provide little guidance as to how they assign relative weights toeach factor" though they do provide information on what variables theyconsider in determining sovereign ratings

A sovereign rating is aimed at measuring the risk that a governmentmay default on its own obligations in either local or foreign currency

!t takes into account both the ability & willingness of a government to

repay its debt in a timely manner !dentifying the relationship between the CAs4 criteria & actual ratingsis difficult as some of the criteria used is neither +uantitative nor+uantifiable but +ualitative

!n assessing sovereign risk" CAs highlight several risk parameters ofvarying importance like economic risk" political risk" fiscal & monetaryflexibility & of course the total debt burden

3conomic isk addresses the ability to repay its obligations on time &is a function of both +uantitative & +ualitative factors

olitical isk addresses the sovereign4s willingness to repay debtwhich is a +ualitative issue that separates sovereigns from most othertypes of issuers


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Actually" political & economic risks are related to each other as agovernment that is unwilling to repay debt is usually pursuingeconomic policies that weaken its ability to do so

#he economic variables aim at measuring ? types of performancesnamely domestic economic performance" country4s external position& its ability to service its external obligations and the influence ofexternal developments

3arlier" CAs4 analysis was focused on traditional macro economicindicators with limited emphasis on contingent liabilities &international li+uidity considerations as also private sector4sweaknesses were not included in the analysis of sovereign rating

!n practice" a small number of variables have a large impact on creditratings. #hese variables include >D per capita" real >D growth per

capita" consumer price index" ratio of government fiscal balance to>D & government debt !n short" (6) igher >D per capita leads to higher ratings (0) igher

C! inflation leads to lower ratings (?) =ower the ratio of governmentfiscal balance to >D" lower the ratings () igher fiscal deficit &government debt in relation to >D leads to lower ratings


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Credit Rating Process

ating e+uestCollection of !nformationanagement eeting

ating Committee and Assignment ofating

Advice to the Client (!ssuer)

Appealublication%urveillance and eview


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Primary Functions of CRAs

Common %cale of Comparison

educe !nformation Asymmetry

!nvestor !nformation and rotection

#ime 3fficiency

Corporate !mage

=ower Cost of isk Assessmentegulation


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Supplementary Functions of CRAs

CAs offer varied services like mutual consultingservices which comprises of operations upgradationand risk management

CAs provide training to the employees and

executives of the companies for better management CAs examine the risk involved in a new pro5ect"

chalk out plans to fight it successfully and thuslessen the percentage of risk largely for which theycarry on a thorough research and development into

the respective industry CAs have started offering services to the mutual

funds sector through the application of fundutili:ation services


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International Regulations on

CRAs

!nternational Ergani:ation of %ecurities Commission (!E%CE) hasformulated a Code of Conduct $undamentals for the working of CAs.

#he Code $undamentals are designed to apply to any CA and anyperson employed by a CA in either in full1time or part1time capacity.

!t focuses on transparency and disclosure in relation to CAmethodologies" conflicts of interest" use of information" performance and

duties to the issuers and public" the role of CA in structured financetransactions" etc.

!t does not dictate business models or governance but rather seeks toprovide the market with information to 5udge and assess the CAactivities" performance and reliability.

#he !E%CE Code of Conduct broadly covers the following areas91

(6)Fuality and integrity of the rating process(0) CA4s independence and avoidance of conflicts of interest

(?) CA4s responsibilities towards the investing public and issuers

() Disclosure of the Code of Conduct and communication with the marketparticipants


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Inestment !rades of Bonds

A bond is considered investment grade or !> if its creditrating is ***1 or higher by %tandard & oor or *aa? orhigher by oody's.

>enerally they are bonds that are 5udged by the ratingagency as likely enough to meet payment obligationsthat banks are allowed to invest in them.

atings play a critical role in determining how muchcompanies and other entities that issue debt" includingsovereign governments" have to pay to access creditmarkets" i.e." the amount of interest they pay on their

issued debt. #he threshold between investment1grade and

speculative1grade ratings has important marketimplications for issuers' borrowing costs.


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Inestment !rades of Bonds

*onds that are not rated as investment1grade bondsare known as high yield bonds or more commonly as

5unk bonds. #he risks associated with investment1grade bonds (or

investment1grade corporate debt) are considerednoticeably higher than in the case of first1classgovernment bonds.

#he difference between rates for first1class governmentbonds and investment1grade bonds is calledinvestment1grade spread.

!t is an indicator for the market's belief in the stability ofthe economy. #he higher these investment1gradespreads (or risk premiums) are" the weaker theeconomy is considered and vice1versa.


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Criticism on Credit Rating Agencies

2ntil the early 67GHs" bond credit rating agencies were paid for their workby investors who wanted impartial information on the credit worthiness ofsecurities issuers and their particular offerings.

%tarting in the early 67GHs" the I*ig #hreeI ratings agencies (%&"oody's & $itch) began to receive payment for their work by the securitiesissuers for whom they issue those ratings" which has led to charges that

these ratings agencies can no longer always be impartial when issuingratings for those securities issuers. %ecurities issuers have been accused of IshoppingI for the best ratings

from these three ratings agencies" in order to attract investors" until atleast one of the agencies delivers favorable ratings.

#his arrangement has been cited as one of the primary causes of the sub1prime mortgage crisis (which began in 0HHG)" when some securities"

particularly mortgage backed securities (*%s) and collaterali:ed debtobligations (CDEs) rated highly by the credit ratings agencies" and thusheavily invested in by many organi:ations and individuals" were rapidlyand vastly devalued due to defaults" and fear of defaults" on some of theindividual components of those securities" such as home loans and creditcard accounts.

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6-Credit Rating & Bonds