Chapter 04 - Credit Rating

7/31/2019 Chapter 04 - Credit Rating

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CREDIT RATING


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What is a Credit Rating?

Opinion of the rating agency on the relative ability and

willingness of the issuer of a debt instrument to meet the debt

service obligations as and when they arise.

Current opinion on credit quality

- Issuers ability and inclination to meet debt obligations in a

timely manner

Performs isolated function of credit risk evaluation

Rating is an issue specific view

Useful in differentiation of credit quality


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The process of assigning a symbol with specific reference to

the instrument being rated, that acts as an indicator of the

current opinion on relative capability on the issuer to

service its debt obligation in a timely fashion

The main focus lies in communicating to the investors the

relative ranking of the default- loss probability for a givenfixed income investment, in comparison with other rated

instruments


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Moodys a rating is an opinion on the future ability and

legal obligation of the issuer to make timely payments ofprincipal & interest on a specific fixed income security. The

rating measures the probability that the issuer will default on

the security over its life, which depending on the instrument,may be a matter of days to 30 years or more. In addition, long

term ratings incorporate an assessment of the expected

monetary loss, should a default occur.


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The Rating agency must do all it can to preserve its credibility

and integrity in the market place. As a primary ingredient of

credibility, the agency must maintain independence from all

interested market forces, including issuers, security underwriters,

or government.

Credit rating is a simple and easy to understand symbolic

indicator of the opinion of a credit rating agency about the risk

involved in a borrowing programme of an issuer with reference

to the capability of the issuer to repay the debt as per terms of

issue.


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What a Credit Rating is Not

General purpose evaluation of issuer

Audit of the issuing company

One time assessment valid over life of the instrument

A recommendation to purchase, sell, or hold a security

Predictors of default

uarantees a ainst losses


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Nature of Credit Rating

1. Rating is based on information

2. Many factors affect rating

3. Rating by more than one agency

4. Monitoring the already rated issues

5. Publication of ratings

6. Right of appeal against assigned rating

7. Rating of rating agencies

8. Rating is for instrument and not for the issuer9. Rating not applicable to equity shares

10. Credit v/s financial analysis

11. Time taken in rating process


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Factors affecting assigned ratings

The following factors generally influence the ratings to be assignedby a credit rating agency:

1. The security issuers ability to service its debt - they calculate thepast and likely future cash flows and compare with fixed interestobligations of the issuer.

2. The volume and composition of outstanding debt.

3. The stability of the future cash flows and earning capacity ofcompany.

4. The interest coverage ratio i.e. how many number of times theissuer is able to meet its fixed interest obligations.

5. Ratio of current assets to current liabilities (i.e. current ratio (CR))is calculated to assess the liquidity position of the issuing firm.


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Factors affecting assigned ratings

6. The value of assets pledged as collateral security and thesecuritys priority of claim against the issuing firms assets.

7. Market position of the company products is judged by thedemand for the products, competitors market share, distributionchannels etc.

8. Operational efficiency is judged by capacity utilisation,prospects of expansion, modernisation and diversification,availability of raw material etc.

9. Track record of promoters, directors and expertise of staff alsoaffect the rating of a company.


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Types of Credit Rating

The following are the common types of rating:

1. Bond rating ( rating the bonds or debt securities)

2. Equity rating

3. Commercial paper rating

4. Sovereign rating (rating a country)


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Functions of a Credit Rating Agency

1. Provides unbiased opinion: An independent credit rating

agency is likely to provide an unbiased opinion as to relativecapability of the company to service debt obligations because ofthe following reasons:

It has no vested interest in an issue unlike brokers, financial

intermediaries.

Its own reputation is at stake.

2. Provides quality and dependable information:. A creditrating agency is in a position to provide quality information oncredit risk which is more authenticate and reliable because:

It has highly trained and professional staff who has better

ability to assess risk.


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Functions of a Credit Rating Agencycont

3. Provides information at low cost: Most of the investors

rely on the ratings assigned by the ratings agencies whiletaking investment decisions. These ratings are published in theform of reports and are available easily on the payment ofnegligible price. It is not possible for the investors to assess thecreditworthiness of the companies on their own.

4. Provide easy to understand information: Rating agencies

first of all gather information, then analyse the same. At last

these interpret and summarise complex information in asimple and readily understood formal manner. Thus in otherwords, information supplied by rating agencies can be easilyunderstood by the investors. They need not go into details ofthe financial statements.


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Advantages of credit rating

Benefits to investors:

1. Safety of investments

2. Recognition of risk and returns

3. Freedom of investment decisions

4. Wider choice of investments

5. Dependable credibility of issuer

6. Easy understanding of investment proposals

7. Relief from botheration to know company

8. Advantages of continuous monitoring


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Advantages of credit ratingcont

Benefits to the company:

1. Easy to raise resources

2. Reduced cost of borrowing

3. Reduced cost of public issues.

4. Rating builds up image

5. Rating facilitate growth

6. Recognition to unknown companies

Benefits to intermediaries:

1. Less efforts in persuading their clients to select aninvestment proposal.

2. Saves time efforts costs and man ower in convincin


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Disadvantages of credit rating

1. Non- disclosure of significant information

2. Static study

3. Rating is no certificate of soundness

4. Rating may be biased

5. Rating under unfavourable conditions

6. Difference in rating grades


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Rating process

1. Mandate

2. Assign Rating Team

3. Receive initial information

4. Secondary data

5. Meetings and visits

6. Preview Meeting

7. Surveillance

8. Committee meeting

9. Rating communication

10. Rating reviews

M d t


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Assign Rating Team

Receive initial information conductbasic research

Meetings and visits

Analysis and preparation of report

Preview meeting

Rating meeting

Assign rating

Communicate the rating and rationale

Acceptance

Mandate

Surveillance

Fresh inputs/clarifications

Request forreview

Non- acceptance


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Risk Assessment Model

INDUSTRYRISK

OPERATINGEFFICIENCY

MARKETPOSITION

FINANCIALRISK

BUSINESSRISK

MANAGEMENTEVALUATION


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Risk Assessment Model

BUSINESSRISK

FINANCIALRISK

MANAGEMENT

EVALUATIO

N

EXISTING RISK

OVERALL RISKRATING

PROJECTRISK


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Industry Risk

Industry Structure

Industry size and importance to economy

Determinants of revenue growth

Entry barriers

Extent of Competition

Nature and basis of competition

Threat from imports and substitutes

Presence of unorganized sector


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Market Position

Market share

Competitive advantages

Brand equity

Pricing flexibility

Product and customer diversityProportion of exports

Nature & type of customer diversity


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Operating Efficiency

Cost structure

Manufacturing efficiency

Production flexibility

Technology risk

Raw material sourcing

Location factors


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Financial Risk Analysis

Accounting Quality

Income recognition

Expense capitalization

Depreciation and inventory valuation policies

Off-balance sheet and contingent liabilities

Non-operating income

Adequacy of Cash Flows

Debt servicing requirements

Sustainability of funds from operations


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Earnings Protection

Profitability measures

Interest coverage

Capital structure

Debt service coverage

Working capital indicators

Return on capital employed

Financial Flexibility

Ability to raise equity and debt funds

Alternatives in times of stress

Liquid assets available


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Management Evaluation

Strength of linkage to parent/ group

Operational, financial, managerial support

Systems and track record

Project implementation record

Management talent and succession

Financial Policies

Attitude to growth and debt orientation


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Project Risk

Project size in relation to existing operations

Means of financing

Funding tie-up

Extent of completion

Adherence to implementation schedules


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RATING FRAMEWORK- Major Factors/Drivers

Business Factors/ Business risk drivers:

1) Nature of industry

2) Market position

3) Efficiency of operation

4) Project risk

5) Protective factors

6) Quality of management


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Financial Factors/ Financial risk drivers:

1) Financing policies

2) Flexibility of financial structure

3) Past financial performance

4) Quality of accounting policy

5) Financial performance indicators

a) Profitability

b) Gearing or level of leveraging

c) Coverage ratios

d) Liquidity position

RATING GRADES OF INTERNATIONAL


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RATING GRADES OF INTERNATIONALRATERS

INVESTMENT GRADE

RATINGS

SPECULATIVE GRADE RATINGS

Name of theagencies

Interpretation

Name of theAgencies Interpretation

S&P andothers

S&Pand

others

Moodys

AAA Highest Quality BB+ Ba1 Likely for fullobligations,ongoinguncertainty

AA+ High Quality BB Ba2 As aboveAA High Quality BB- Ba3 As above

AA - High Quality B+ B1 High riskobligations

A+ Strong payment B B2 High risk


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S&P and others S&Pandothers

Moodys

Interpretation

BBB+ Adequatepayment

capacity

CCC Caa As above

BBB Adequatepaymentcapacity

CCC- As above

BBB - Adequatepaymentcapacity

C Ca In bankruptcy orin default, orother markedshortcomings

D D In bankruptcy orin default, or

I t t I f ti d C dit R ti A f I di


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Investment Information and Credit Rating Agency of India( ICRA)

ICRA Limited was incorporated on January 16, 1991 andlaunched its services on August 31, 1991.

It is an independent and professional company providinginvestment information and credit rating services.

ICRA has broad based its services to the corporate andfinancial sectors, both in India and overseas, and

presently provides its services under three banners:

Rating services

Information services

Advisory services


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ICRA ( Investment Information and CreditRating Agency of India Limited)

1) Long-term Debt - Debentures, Bonds and Preference shares

Symbol Indicator Profile

LAAA Highest safety Indicates fundamentally strongposition

Risk factors are negligibleVisualization of anycircumstancesadversely affecting the degree of

safety

Timely payment of principal andinterestas per terms will not be affected

LAA+

LAALAA-

High safety Modest & slightly varying risk

factors Strong protective factors


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LA+LA

LA-

Adequate safety Risk factors are more variable &greater

in periods of economic stress Protective factors are average Any adverse change incircumstancesalthough could be visualized,

may alterthe fundamental strength and

affect thetimely payment of principal &

interest as

per terms

LBBB+LBBBLBBB-

Moderate safety Considerable variability in riskfactors Protective factors are below

average dverse chan es in business/


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LB+LB

LB-

Risk prone Risk factors indicate that theobligations

may not be met when due Adverse changes in business/economicconditions could result in

inability/

unwillingness to service debts ontime asper terms

LC+

LCLC-

Substantial risk Presence of inherent elements of

risk &timely servicing of debts/

obligationscould be possible only in case ofcontinued existence of favorable

circumstances

2)M di t D bt i l di Fi d D it


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2)Medium-term Debt - including Fixed DepositPrograms


MAAA Highestsafety

Best prospect of timelyservicing of interest &principal as per terms

MAA+MAAMAA-

High safety prospect of timely servicingof the interest & principal asper terms is high, but not ashigh as in MAAA rating

MA+MAMA-

Adequatesafety

adequate prospect oftimely servicing of interest &principal debt servicing mayhowever, be affected by


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MC+

MCMC-

Risk prone high susceptibility to

default adverse changes inbusiness/economicconditions could result ininability/ unwillingness toservice debts on time & asper terms

MD Default either already in default orexpected to default


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3)Short -term Debt - including Commercial Paper


A1+A1

Highestsafety

Best prospect of timelypayment of

debt/ obligation

A2+

A2

High safety Relative safety is

marginally lower thanA1 rating

A3+A3

Adequatesafety

Prospect of timely paymentof interest

& installment is adequate,but anyadverse change in

business/ economicconditions may affect the

fundamental

C dit R ti I f ti S i f I di li it d


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Credit Rating Information Services of India limited(CRISIL)

It began operations in the year 1987, offering credit rating services ina market where the concept was totally new.

Interest rates at that time were government determined, andCRISILs business was therefore built entirely on guiding the marketfor its investment decisions.

Objectives:

1. To assist investors in making investment decisions.

2. To assist issuers in raising funds from a wider investor base.

3. To provide a marketing tool to entities placing debt with

clients.

4. To provide regulators with a market driven system for bringingabout the development of the capital markets.

5. To institutionalize a viable and market- driven system of credit

rating in India.

St t


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Strategy

The strategy that emerged was three- fold:

1. Creating awareness of the concept amongst all market

participants.

2. Winning credibility, confidence and trust of participants.

3. Generating ratings business that would increase in size asa system of market driven interest rates into play.


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CRISIL ( CREDIT RATING & INFORMATIONSERVICES OF INDIA LTD.)

1) Debenture Rating Symbols

Symbol Indicator

AAA ( Triple A) Highest safety

AA ( Double A) High safety

A Adequate safety

BBB ( Triple B) Moderate safety

BB ( Double B) Inadequate safety

B High risk

C Substantial risk

D Default


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NOTE:

1) CRISIL may apply + or - signs for ratings from AA toC to reflect comparative standing within the category.

2) The contents within parentheses are a guide to thepronunciation of the rating symbols.

3) Preference share rating symbols are identical to debenturerating symbols except that the letters pf are prefixed to theraring symbols, e.g., pfAAA.


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CRISIL Fixed Deposit Rating Symbols

Symbol Indicator

FAAA ( F Triple A) Highest Safety

FAA ( F Double A) High Safety

FA Adequate SafetyFB Inadequate Safety

FC High Risk

FD Default


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CRISIL RATINGS FOR SHORT- TERM INSTRUMENTS

Symbol Indicator

P-1 Highest Safety

P-2 High SafetyP-3 Adequate Safety

P-4 High risk

P-5 Default

C di A l i d R h Li i d (CARE)


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Credit Analysis and Research Limited (CARE)

CARE was incorporated in April 1993.

It is a credit rating, information and advisory services companypromoted by Industrial Development Bank of India (IDBI), CanaraBank, Unit Trust of India and other leading banks and financial

services companies.

Ad i i b CARE


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Advisory services by CARE

Credit reports

Sector studies

Project Advisory Services

Financial Restructuring

Valuation

Debt market review

Rating services

EQUITY GRADING BY ICRA


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EQUITY GRADING BY ICRA-METHODOLOGY

1) Developing benchmarks

2) Comments on safety levels

3) Fundamental analysis

4) Analysis of factors

5) Obtaining opinions


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EQUITY GRADING PROCESSBY ICRA

1) Mandate from the issuer

2) Assigning team of analysts

3) Data collection

4) Data analysis

5) Discussions

6) Credit report

7) Grade communication

EQUITY GRADES OF ICRA


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EQUITY GRADES OF ICRA


ERA 1 Excellentearningprospects &low risk

Earning prospects over themedium- term are of thehighest grade changes in business /economic circumstances, as

may be visualized, areunlikely to significantlyimpair the underlyingfundamentals

ERA 2 Excellentearningprospects &moderate risk

Earning prospects over themedium- term are of thehighest grade changes in business /economic circumstances, asmay be visualized, may


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ERB 1 Good earningprospects & lowrisk

Earning prospects overthe medium- term are ofthe highest grade

changes in business /economic circumstances,as may be visualized, areunlikely to significantlyimpair the underlyingfundamentals

ERB 2 Good earningprospects &

moderate risk

Earning prospects overthe medium- term are of

a high grade changes in business /economic circumstances,as may be visualized,

may adversely affect the

ERC 1 Moderate E i t th


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ERC 1 Moderateearningprospects &

low risk

Earning prospects over themedium- term are moderate changes in business /

economic circumstances, asmay be visualized, areunlikely to significantly impairthe underlying fundamentals

ERC 2 Moderateearningprospects &moderate

risk

Earning prospects over themedium- term are moderate changes in business /economic circumstances, as

may be visualized, mayadversely affect theunderlying fundamentals

ERC 3 Moderateearning

ros ects &

Earning prospects over themedium- term are moderate chan es in business /

ERD 1 Poor Earning prospects over the


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ERD 1 Poorearningprospects &

low risk

Earning prospects over themedium- term are low changes in business /

economic circumstances, asmay be visualized, areunlikely to significantly impairthe underlying fundamentals

ERD 2 Poorearningprospects &moderate

risk

Earning prospects over themedium- term are low changes in business /economic circumstances, as

may be visualized, mayadversely affect theunderlying fundamentals

ERD 3 Poorearning

ros ects &

Earning prospects over themedium- term are low chan es in business /

C iti i i t dit ti i


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Criticisms against credit rating agencies

Independence of ratings is questionable

CRAs are not accountable for ratings given by them

Ratings may lead to herding behaviour therebyincreasing the volatility of the capital flows

Rating agencies are unable to constantly monitordevelopments

Rating agencies need to maintain expert professionalstaff lawyers, CAs, CS, MBA, finance analysts,

bankers, etc.

SEBI id li f C dit R ti A i


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SEBI guidelines for Credit Rating Agencies

Only commercial banks, public financial institutions, foreign

banks operating in India, foreign credit rating agencies, andcompanies with a minimum net worth of Rs. 100 crore as per itsaudited annual accounts for the previous five years are eligible to

promote rating agencies in India .

Rating agencies cannot assess financial instruments of theirpromoters who have more than 10 % stake in them.

Rating agencies are required to have a minimum net worth of Rs.5 crores.


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Rating agencies cannot rate a security issued by anentity which is a borrower of its promoter or a

subsidiary of its promoter or an associate of itspromoter, if

(1) there are common chairmen, directors between

credit rating agency and these entities

(2) there are common employees

(3) there are common chairmen, directors, employees

on the rating committee


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Rating agencies cannot rate a security issued by itsassociate or subsidiary, if the credit rating agency orits rating committee has a chairman, director or

employee, who is also a chairman, director oremployee of any such entity

A penalty of suspension of the certificate ofregistration or a penalty of cancellation of registrationmay be imposed on the rating agency if it fails tocomply with any condition or contravenes any of the

provisions of the act


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CRAs will keep a record of discussion summary withissuer, management and auditors.

- CRAs will also be required to maintain records of

voting details of the rating committee for five

years after the maturity of the instrument

.- CRAs will formulate policies for conflict of interests.

- Individuals in the credit rating process will not beallowed to hold shares of the issuer.

- CRAs will be required to disclose methodology of


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SEBI has made it compulsory for CRAs to have

internal audits conducted on a half-yearly basis, thatwould cover all aspects of CRAs operations andprocedures, including investor grievance redressalmechanism.

At present, there are five registered CRAs in India,including CARE, Icra, Fitch, Crisil and BrickworkRatings India.

Documents

Chapter 04 - Credit Rating