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Unit 13

Unit 13

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Published by: ritzchavan on Oct 06, 2009
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UNIT
13
CREDIT RATING AGENCIESIN INDIA
9
Structure
13.0 Objectives13.1 Introduction13.2 Meaning of Credit Rating13.3 Determinants of Credit Rating13.4 Rating Methodology13.5Credit Rating Agencies in India13.6 Credit Rating Symbols13.7 Benefits of Credit Rating13.8 Rating and Default Risk13.9 Ratings and Yields13.10 Limitations of Credit Ratings13.11 Let
Us
Sum Up13.12 Key Words13.13 Useful Books13.14 AnswersIHints to Check Your Progress
13.0 OBJECTIVES
After going through this Unit, you will be able to
:
Explain the meaning and determinants of credit rating,Illustrate the rating methodology,Describe the advances and limitations of credit rating,Identify the credit rating symbols, andDiscuss credit rating agencies in India.
13.1
INTRODUCTION
The removal of strict regulatory framework in recent years.has led to a spurt in the number of companies borrowingdirectly from the capital markets. There have been severalinstances in the recent past where the "fly-by-nightnoperators have cheated unwary investors. In such
a
situation,it has become increasingly difficult for an ordinary investorto distinguish between 'safe and good investmentopportunities' and 'unsafe and bad investments'. Investorsfind that a borrower's size or name are no longer
a
sufficientguarantee of timely payment of interest and principal.Investors perceive the need of an independent and credibleagency, which judges impartially and in
a
professionalmanner, the credit quality of different companies and assistinvestors in making their investment decisions. Credit RatingAgencies, by providing
a
simple system of gradation ofcorporate debt instruments, assist lenders to form an opinionon -the relative capacities of the borrowers to meet their
5
I
 
Financial and Investment
obligations. These Credit Rating Agencies, thus, assist and
Institutions in
India
form an integral part of a broader programme of financialdisintermediation and broadening and deepening of thedebt market.Credit rating is used' extensively fqr evaluating debtinstruments. These include long-term instruments, likebonds and debentures as will as short-term obligations,like Commercial Paper. In addition, fured deposits, certificatesof deposits, inter-corporate deposits, structured obligationsincluding non-convertible portion of partly ConvertibleDebentures (PCDs) and preferences shares are also rated.The Securities and Exchange Board of India (SEBI), theregulator of Indian Capital Market, has now decided toenforce mandatory rating of all debt instruments irrespectiveof their maturity. Let us recall that earlier only debt issues
"
of over
18
months maturity had to be compulsorily rated.
13.2
MEANINGOFCREDIT RATING
Credit Rating Agencies rate the aforesaid debt instrumentsof companies. They do not rate the companies, but theirindividual debt securities.
Rating is an opinion regardingthe timely repayment of principal and interest thereon; It isexpressed by assigning symbols, which have definitemeaning.
A
rating reflects default risk only, not the price risk associatedwith changes in the level or shape of the yield curve. It isimportant to emphasise that credit ratings are notrecommendations to invest. They do not take into accountmany aspects, which influence an investment decision. Theydo not, for example, evaluate the reasonableness of theissue price, possibilities of earning capital gains or take intoaccount the liquidity in the secondary market. Ratings alsodo not take into account the risk of prepayment by theissuer, or interest rate risk or exchange rate risks. Althoughthese are often related to the credit risk, the rating essentialis an opinion on the relative quality of the credit risk.. Ithas to be noted that there is no privity of contract betweenan investor and
a
rating agency and the investor is notprotected by the opinion of the rating agency.
Ratings arenot a guarantee against loss.
They are simply opinions,based on analysis of the risk of default. They are helpfulin making decisions based on particular preference of riskand return.
A
company, desirous of rating its debt instrument, needs toapproach
a
credit rating agency and pay
a
fee for thisservice. There is no compulsion on the.corporate sector to
.
obtain' or publicize the credit rating except for certaininstruments.
A
-company can use the rating as another
mlhliritv
rri~
<if it
i~
a
unnd nir~
and
tn nhlitmt~ t
 
from
its prospectus and publicity, if it is not good. TheCredit Rating Agencies regularly analyse the financialposition of corporations and assign and revise the ratingslor their securittes. The different rating agencie.~ eldomgive different ratings for the same security.
If
two ratingagencies do give the same security diflerent ratings, it iscalled
split rating;
the few differences that occur are rarelymore than one rating grade level apart. Accepted ratings arepublished in media, every week. In tune with the industrialpractice in India, rating agencies do not publish ratingswhich are nqt accepted by issuers.
*,
Age
Credit
Rating
lncies in
India
'
13.3
THE DETERMINANTS OF RATINGS
The default-risk assessment qnd quality rating assigned toan issue are primarily determined by three factors
-
i)
The issuer's ability to pay,
ii)
'
The strength of the security owner's claim on the issue, andiii) The economic significance of the industry and market placeof the issuer..Ratio analysis is used to analyse the present and futureearning power of the issuing corporation and to get insightinto the strengths and weaknesses of the firm. Bond ratingagencies have suggested guidelines about what value eachratio should have within a particular quality rating. Differentratios are favoured by rating agencies. For any given set ofratios, different values are appropriate for each industry.Moreover, the values of every firm's ratios vary in a cyclicalfashion through the ups and downs of the business cycle.To assess the strength of security owner's claim, theprotective provisions in the indenture (legal instrumentspecifying bond owners' rights), designed to ensure thesafety of bondholder's investment, are considered in detail.The factors considered in regard to the economic significanceand size of issuer includes: nature of industry 'in whichissuer is, operating (specifically issues like position in theeconomy, life cycle of the industry, labour situation, supply
--
-
factors, volatility, major vulnerabilities, etc.), and thecompetition faced by the issuer (market share, technologicalleadershlp, production efficiency, findncial structure, etc.)
13.4
RATING METHODOLOGY
kating is
a
search for long-term fundamentals and thepr,obabilities for changes in the fundamentals. Each agency'srating process usually includes fundamental analysis of publicand private issuer-specific data, 'industry analysis, and
--

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