You are on page 1of 30

CREDIT RATING ASPECTS

What is CREDIT RATING ?
‡ A credit rating estimates the credit worthiness of an individual, corporation, or even a country. ‡ It is an evaluation made by an agency (bureaus) of a borrower s overall credit history. ‡ A credit rating is also known as an evaluation of a potential borrower's ability to repay debt, prepared by an agency at the request of the lender. ‡ A poor credit rating indicates a high risk of defaulting on a loan, and thus leads to high interest rates, or the refusal of a loan by the creditor.

‡ Credit ratings are calculated from financial history and current assets and liabilities. ‡ Typically, a credit rating tells a lender or investor the probability of the subject being able to pay back a loan. ‡ In recent years, credit ratings have also been used to adjust insurance premiums, determine employment eligibility, and establish the amount of a utility or leasing deposit.

What it is and what it is not ?
What a rating is:
‡ A current opinion on the relative creditworthiness of debt ‡ An issue specific evaluation ‡ Aimed at differentiating credit quality

What a rating is not:
‡ ‡ ‡ ‡ Not an audit of the issuing company Not a one time assessment of creditworthiness of the issuer Not a general purpose certification of goodness of a company Not a recommendation to buy, hold or sell the rated security

When CREDIT RATING started ?
‡ The initial rating exercise was started by Henry Poor who published financial statistics of Railroad companies in 1860. ‡ In addition to his publishing business, John Moody (Moody s Investors Services) started publishing ratings for railroad bonds from the year1909. ‡ The rating activity got a boost post Great Depression of 1933 when US Government Controller of Currency directed the banks in USA to purchase bonds rated BBB and above and the rest came to be known as junk bonds. At present in US markets all commercial bonds are invariably rated.

What can be CREDIT RATED ?
‡ INDIVIDUAL An individual's credit score, along with his or her credit report, affects his or her ability to borrow money through financial institutions such as banks. ‡ CORPORATE The credit rating of a corporation is a financial indicator to potential investors of debt securities such as bonds. ‡ SOVEREIGN A sovereign credit rating is the credit rating of a sovereign entity, i.e. a country. The sovereign credit rating indicates the risk level of the investing environment of a country and is used by investors looking to invest abroad. It takes political risk into account.

‡FINANCIAL INSTRUMENTS
Bonds Bank Deposits Commercial Paper Term Loans Preference Shares Secured Debt Unsecured Debt Mortgage Backed Securities Asset Backed Securities Structured Obligations ‡ These can be issued by Sovereigns, Manufacturing/ Service Companies ,Statutory Bodies/Public Sector Companies, Financial Institutions & Banks, Finance Companies, Credit Unions, Holding Companies, Insurance Companies and Mutual Funds

Where is CREDIT RATING emerging ?
‡ ‡ ‡ ‡ ‡ ‡ Equity Research Banking Sector Insurance Sector New Instruments viz. Floating Rate Notes Intermediary in Financial Sector Indian Corporate raising funds overseas

Who uses CREDIT RATING ? Investors
1. Eases risk identification and diversification 2. Risk based pricing of Investments 3. Greater depth of research, being locally based Issuers 1. A proactive step towards transparency 2. An independent, unbiased assessment 3. Enhances credibility & acceptability 4. Increases access to funding 5. Encourages financial discipline Regulatory authorities 1. Investor protection 2. Market discipline Intermediaries 1. Fixing coupon rates 2. A second opinion

What is a CREDIT RATING AGENCY ?
‡ A credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. ‡ In some cases, the servicers of the underlying debt are also given ratings. ‡ In most cases, the issuers of securities are companies, special purpose entities, state and local governments, non-profit organizations, or national governments issuing debt-like securities (i.e., bonds) that can be traded on a secondary market.

Which are the CRA in INDIA ?
‡ Credit Rating Information Services of India Limited (CRISIL) ‡ Investment Information and Credit Rating Agency of India (ICRA) ‡ Credit Analysis & Research Limited (CARE) ‡ Duff & Phelps Credit Rating India Private Ltd. (DCR India) ‡ ONICRA Credit Rating Agency of India Ltd.

What CRA should comply with ?
‡ The Securities and Exchange Board of India (Credit Rating Agencies) Regulations, 1999 offers various guidelines with regard to the registration and functioning of the credit rating agencies in India. ‡ The registration procedure includes application for the establishment of a credit rating agency, matching the eligibility criteria and providing all the details required. ‡ They are required to prepare internal procedures, abidance with circulars. ‡ CRA are required to show their accounting records.

What is process of CREDIT RATING ?

Why are financial instruments rated ?
‡ Developments in the financial markets have focused attention on the need to have proper understanding of the terms of financial instruments, before selecting them for investment. ‡ Even sophisticated investors, in both domestic as well as international markets, are complaining about investing in an inappropriate instrument without fully comprehending the risks involved. ‡ Rapid developments in financial markets aided by technology, requires an investor to have proper understanding of features of instruments, especially the more sophisticated ones, before investing in them.

What is the criteria for instruments ?
‡ CERTAINTY OF RATE OF RETURN ‡ PRE-MATURE REDEMPTION ‡ NUMBER OF PARTIES INVOLVED IN THE TRANSACTION ‡ FAMILIARITY OF CAPITAL MARKET WITH THE INSTRUMENT

What is the complexity in financial instruments ?
Instruments are classified into three categories based on the complexity involved in the comprehension of these instruments. ‡ SIMPLE These are generally, instruments with a fixed rate of return with a pre-determined repayment period. They do not have any prepayment risk and number of counter parties is only one. Capital market participants are very familiar with the instrument.

‡ COMPLEX These are generally, instruments with a variable rate of return. While the repayment period may be fixed, there is a risk of pre-payment and number of counter parties may be more than one. Capital market participants may be only moderately familiar with the instrument. ‡ HIGHLY-COMPLEX They generally have a variable return and maturity profile. Number of counterparties involved may be more than one. Capital market participants are not very familiar with the instrument.

COMPLEXITY v/s CREDIT RISK
‡ Classification of instruments based on complexity should not be misconstrued as an indicator of inherent credit risk of the instrument. ‡ Even instruments classified as Simple may have a higher credit risk comparable to those classified as Complex or Highly Complex. ‡ For example, while Fixed Deposits, which are unsecured in nature, are simple instruments to transact, the credit risk may be higher than that of Highly Complex instrument like Asset Backed Securities.

What is the methodology of CREDIT RATING ?
Various Credit Rating Agencies use various methods. The general methods are The first method : ‡ Business Analysis Industry risk, market position and operating efficiency of the company, legal position. ‡ Financial Analysis Accounting quality, earnings position, adequacy of cash flows, and financial flexibility.

‡ Management Evaluation Goals, philosophy, strategies, ability to overcome adverse situations, managerial talents and succession plans, commitment, consistency and credibility. ‡ Regulatory and Competitive Environment ‡ Fundamental Analysis Liquidity management, assets quality, profitability and financial position, interest and tax sensitivity. In this method all these factors are analyzed and interpreted and after that the rating is done.

The second method :
The rating methodology comprises the study of industry as well as the company s SWOT analysis. Marketing strategies Competitive edge Level of technological development Operational efficiency

‡ ‡ ‡ ‡

‡ Competence and effectiveness of management ‡ HRD policies and practices ‡ Hedging of risks ‡ Cash flow trends and potential ‡ Liquidity ‡ Financial flexibility ‡ Asset quality and past record of servicing debts and obligations ‡ Government policies and status affecting the industry

What are the symbols used ?
‡ Various agencies uses various symbols for denoting the ratings. ‡ The rating scales are generally AAA, AA, A, BBB, BB, D..etc ‡ The prefixes are added so as to denote the type of instrument. They are: Pref. shares: Pf Fixed Deposits: F Short Term Instruments: P ‡ Also prefixes are also used to denote whether they are long /medium/short term. Long: L Medium: M

AAA/AA are considered High Investment Grades. A/BBB are considered Investment Grades. BB/B/C/D are considered speculative grades. Additionally, (+) or (-) signs are used to denote higher or lower safety within the grade (AA+, AAetc.) ‡ Generally for short term - A1, A2, A3, A4, A5 are used for rating. ‡ Some agencies use P instead of A ‡ The symbols can also be called as the rating scales. ‡ ‡ ‡ ‡

What are the Short term symbols ?
‡ The short term include money market instruments like commercial papers etc. A-1/P-1: Highest Safety A-2/P-2: High Safety A-3/P-3: Adequate Safety A-4/P-4: Risk prone A-5/P-5: Default (which give no return or will definitely default)

What are the medium term symbols?
‡ The medium term instruments include instruments ranging 2 to 5 years, generally like certificate of deposits and fixed deposits. MAAA: Highest Safety MAA: High Safety MA : Adequate Safety MB : Inadequate Safety MC : Risk prone MD : Default

What are the long term symbols ?
‡ The long term sources include long term Debentures, Bonds, Preference shares and equities. LAAA : Highest Safety LAA : High Safety LA : Adequate Safety LBBB : Moderate Safety LBB : Inadequate Safety LB : Risk prone LC : Substantial Risk LD : Default, Extremely speculative

Why are CR/CRA criticized ?
‡ Credit rating agencies do not downgrade companies promptly enough. For example, Enron's rating remained at investment grade four days before the company went bankrupt, despite the fact that credit rating agencies had been aware of the company's problems for months. ‡ Large corporate rating agencies have been criticized for having too familiar a relationship with company management, possibly opening themselves to undue influence or the vulnerability of being misled.

‡ The lowering of a credit score by a CRA can create a vicious cycle, as not only interest rates for that company would go up, but other contracts with financial institutions may be affected adversely, causing an increase in expenses and ensuing decrease in credit worthiness. ‡ Credit Rating Agencies have made errors of judgment in rating structured products, particularly in assigning AAA ratings to structured debt, which in a large number of cases has subsequently been downgraded or defaulted. ‡ Rating agency business is itself reputation-based and the finance industry pays little attention to a rating that is not widely recognized.

Source
‡ www.crisil.com ‡ www.icra.in ‡ www.careratings.com