UNIT 6 CREDIT RATING

Meaning
Credit rating is simply an opinion on the future ability and legal obligation of an issuer to make timely payments of principal and interest on a specific fixed income security. According to Credit Rating Agencies Regulations, 1999, rating means: An opinion regarding securities Expressed in the form of standard symbols Assigned by a credit rating agency Used by an issuer of such securities

Credit rating is a symbolic indicator of the current opinion of the relative capability of an issuer to service its debt obligation in time. The primary objective of rating is to provide guidance to investors/creditors in determining a credit risk associated with a debt instrument/credit obligation. Credit rating is flexible in nature.

Functions of Credit rating:

1. Provide unbiased opinion :An independent credit rating agency is likely to provide an unbiased opinion as to relative capability of the company to service debt obligation because of the following reasons:i. It has no vested interest in an issue unlike brokers, financial intermediaries. ii. Its own reputation is at stake 2. Provides quality and dependable information :A credit rating agencies is in a position to provide quality information on credit risk which is more authenticated and reliable because i. It had highly trained and professional staffs who has better ability to access risk. ii. It had access to a lot of information which may not publically available. 3. Provide information at low costs :Most of the investors rely on ratings assigned by the rating agencies while taking investment decisions. These ratings are published in form of reports and are available easily on payment of negligible price. It is not possible for investors to assess the creditworthiness of the companies on their own. 4. Provide easy to understand information :-

Rating agencies first of all gather information, and then analyze the same. At last these interpret and summarize complex information in sample and readily understood formal manner. Thus in other words, information supplied by rating agencies can be easily understood by the investors, they need not go into details of the financial statement. 5. Provide basis of investment :An investment rated by credit rating enjoys higher confidence from investors. Investors can make an estimate of the risk and return association with a particular rated issue while investing money in them. 6. Healthy discipline on corporate borrowers :Higher credit rating to any credit investment enhance corporate image and builds up goodwill and hence it includes a healthy discipline on corporate. 7. Formations of public policy :Once the debt securities are rated professionally, it would be easier to formulate public policy guidelines as to the eligibility of securities to be included in different kinds of institutional port-folio.

Advantages of Credit Rating

It is beneficial to the investor, the rated instrument issuing company, intermediaries and others. The advantages for each group are listed below:

To Investors
1. Assessment of credibility rating assesses the strength and weakness of the company/debt instrument on the basis of certain predetermined factors. The assessment is carried out judiciously and impartially. Hence, it is beneficial to the investor to understand the credibility of the issuing company. 2. Risk indicator a credit rating agency rates the instruments after analyzing the various aspects of the company. All the investors may not possess the required knowledge and information for credit evaluation, but the investors can identify the risk associated with them with the symbols assigned to the instruments by the credit rating agency. They can compare the return and the risk involved in investing in a particular security. 3. Protects against bankruptcy - the financial strength of the issuing company is assessed through credit rating. High rating assigned to the debt security of a company indicates a safe investment. 4. Easy to understand the rating is given in the form of symbols. Once the symbols are clearly explained, it is easy to understand and use them. No analytical knowledge is required to understand the rating.

5. Enables quick decisions an investor can take quick decisions based upon the rating. There is no need for him to study or know the fundamentals of the company, its actual strength, financial standing, management details etc. This saves the energy and time of the investor and helps him to take quick decisions. 6. Independent decisions the investor can build his own portfolio without the help of the portfolio managers by carefully watching upgrades and downgrades of the credit rating, he can alter his portfolio mix. 7. Portfolio diversification large investors may use credit rating for portfolio diversification by selecting appropriate instruments from a broad spectrum of investment options. 8. Rating surveillance rating is not a one-time business. It is a continuous process. Rating agencies continuously watch the financial strength and other related factors of the company. 9. Other services the rating agencies conduct research studies, provide industry reports, seminars and open access to analysts for discussion. Thus rating protects the investors interest and facilitates wise investment decision.

To Issuers
1. Lowers the cost of borrowing the investors who are interested in the safety of the instrument, do not mind the marginal decline in the rate of interest. The issuing company could borrow at a low rate of interest. 2. Widens investor base the issuers of rated securities are likely to have access to a much wider investor base as compared to unrated securities. The rating itself is used as an advertising tool to raise funds in various media. 3. Fosters a better image rating creates a better image for an issuer. An issuer himself improves his image when he has to get the rating. Hence, it builds a better image for the rated instrument. 4. Induces self discipline rating requires the disclosure of accounting system, financial reporting and management pattern. This disclosure imposes self discipline on the functioning of the company. 5. Lowers the cost of issue a higher rating makes it more accessible to the investor. There is no need to have wide publicity or adopt other ways of publicity. This reduces the cost of the public issue. Rating could be used as a benchmark for issue pricing. 6. Motivates growth rating instills a feeling of confidence and encourages the entrepreneurs to undertake new projects and expand the existing projects.

To Intermediaries

Rating helps the merchant bankers and other capital market intermediaries in their ventures. 1. It enables proper planning, pricing, underwriting and placement of the issues. Brokers and dealers could use ratings to monitor their risk exposures. 2. This saves their time, cost, energy and manpower in analyzing the investment risk. 3. Rating is also used in securitization of assets and helps the special purpose vehicle to repackage the assets.

Limitations of Credit Rating

1. Rating does not recommend buying or selling a high credit rating should not be considered as a recommendation for buying or selling. The companys earning and growth prospect are more important. Credit raters are more interested in the companys solvency and its ability to repay its debt, especially during recession. 2. It is issue specific rating is given for a particular instrument or issue and not for the company. It is possible for two issues of the same company to have different ratings depending on the characteristics of the instruments. Rating also depends on the terms and conditions of the particular instrument. 3. Possibility of getting different rating credit ratings are opinions of the credit rating agencies on debt issues of companies. It is quite possible to get different ratings for the same company from two different agencies. 4. Review lag rating agencies review ratings of a new issue before they hit the market. This means that there might have been a change in the credit quality of the company in the interim period, which might not have been considered by the rating agencies.

Classification of Credit Rating

1. Debenture and Bond Rating long-term instruments like debentures and bonds of corporate bodies, governments and quasi governments are rated by the rating agencies. Debenture rating is the primary and major business of the rating agencies. 2. Equity Rating the rating of equities of the companies is called equity grading. Equity rating is very common in international capital market. At present, equity rating is undertaken by rating agencies in India. 3. Fixed Deposit and Certificate of Deposit Rating these are the medium-term instruments rated by the rating agencies. The fixed deposit provisions offered by the finance companies and corporate bodies are rated to ensure their safety and security. 4. Commercial Paper Rating this short-term instrument is also rated by the agencies. Reputed corporate bodies issue commercial papers to the public and financial institutions. Its main objective is to raise short-term capital

5. LPG/Kerosene Dealers/Firms Rating the objective is to help the consumers identify the genuine companies before applying for a connection. It is made mandatory for the companies to disclose their rating to the public. Rating certificates have to be taken from CRISIL/CARE/ICRA. 6. Chit Funds Rating CRISIL rates chit funds incorporated as public or private companies with a minimum net worth of Rs 5 lakhs and an operating track record of 10years. It is not mandatory for these chit funds to get rated, but some of them get themselves rated. 7. Real Estate Developers Rating this rating is for a particular project and not for the company as a whole. Projects with approved plans and necessary planning permits are taken up for rating. CRISIL undertakes the rating of real estate projects. 8. Banks Rating the debt servicing ability of a bank is rated. The Bank of Baroda and The State Bank have been rated by a rating agency. CRISIL and ICRA also rates banks. The CRAMEL model has been adopted for rating banks, i.e., C (capital adequacy), R (resource raising ability), A (asset quality), M (management evaluation), E (earning potential), L (liquidity). 9. Rating of Structured Obligation the structured instruments is credit rated in the case of securitization. Credit rating provides an objective assessment of the default risk of the structured instruments. 10. Sovereign Rating the credit worthiness of a country and its credit probable risks are rated. Depending on the potential and economic development that takes place in a country, the sovereign ratings are upgraded or downgraded. 11. Customer Rating customers paying capacity is rated with regard to debt in due time .

Credit Rating Agencies

1. Standard & Poors Standard & Poor's (S&P) is an American financial services company that publishes financial research and analysis on stocks and bonds. As a credit-rating agency (CRA), the company issues credit ratings for the debt of public and private corporations. S&P is known for its stock market indices such as the U.S.-based S&P 500, India's S&P CNX Nifty and so on. 2. Moodys Moody's Investors Service, often referred to as Moody's, is the bond credit rating business of Moody's Corporation

The company ranks the creditworthiness of borrowers using a standardized ratings scale which measures expected investor loss in the event of default. Moody's Investors Service rates debt securities in several market segments related to public and commercial securities in the bond market. In Moody's Investors Service's ratings system securities are assigned a rating from Aaa to C, with Aaa being the highest quality and C the lowest quality.

3. Fitch Fitch Ratings is the smallest of the "big three" NRSROs, covering a more limited share of the market than S&P and Moody's, though it has grown with acquisitions and frequently positions itself as a "tie-breaker" when the other two agencies have ratings similar, but not equal, in scale. Credit Rating Agencies in India 1. CRISIL CRISIL is acronym for Credit Rating Information Services of India Limited. CRISIL is India's leading Ratings, Financial News, Risk and Policy Advisory company. CRISIL's majority shareholder is Standard & Poor's, the world's foremost provider of independent credit ratings, indices, risk evaluation, investment research and data. 2. Investment Information and Credit Rating Agency of India (ICRA). 3. Credit Analysis and Research (CARE) 4. Duff Phelps Credit Rating Pvt. Ltd. (DCR India)

Functions of CRISIL
1.Ratings CRISIL Ratings: It is the only ratings agency in India with sectoral specialization It has played a critical role in the development of the debt markets in India. The agency has developed new ratings methodologies for debt instruments and innovative structures across sectors. CRISIL Ratings provides technical know-how to clients all over the world and has helped set up ratings agencies in Malaysia (RAM), Israel (MAALOT) and in the Caribbean. 2. Research CRISIL Research: It provides research, analysis and forecasts on the Indian economy, industries and companies to over 500 Indian and international clients across financial, corporate, consulting and public sectors. CRISIL Fund Services: It provides fund evaluation services and risk solutions to the mutual fund industry

3. Advisory CRISIL Infrastructure Advisory: It provides policy, regulatory and transaction level advice to governments and leading organisations across sectors. Investment and Risk Management Services: CRISIL Risk Solutions offers integrated risk management solutions and advice to Banks and Corporates by leveraging the experience and skills of CRISIL in the areas of credit and market risk.

Rating Process/ Methodology for credit rating

Credit rating includes a pre-visit desk analysis, on-site evaluation, and final report. The entire process from the desk analysis to final report delivery is about 6-8 weeks.

The credit rating process starts with the receipt of the rating request by the CRA (credit rating agency) who keeps the information confidential. Then, the analytical team is assigned to examine the site for better understanding with the companys executives. Factors that are analysed before rating: 1. Business RiskThe business risk that an issuer is exposed to is a combination of the industry risk in its major product segments and its competitive position within the industry. 2. Industry RiskThe objective here is to understand the attractiveness of the industry in which the issuer operates. The aspects examined include the demand-supply position, competitive intensity, the bases of competition, and the various sources of vulnerability. Favourable industry characteristics would include good demand growth, stable operating margins, and moderate capital intensity. 3.Competitive PositionAn assessment of the issuers competitive position within an industry is made on the basis of its operating efficiency as well as its market position. Some of the factors assessed are: Scale of

operations Vintage of technology used Capital cost position Location advantage in terms of proximity to raw material sources as well as markets, Operating efficiencies, ability to command premium pricing, and relationship with key customers. 4.New Project RiskThe scale and nature of new projects can significantly influence the risk profile of an issuer. Unrelated diversification into new products is invariably assessed in greater detail. Besides the rationale for new projects, the other factors that are assessed include: (i) track record of the management in project implementation; (ii) experience and quality of the project implementation team; (iii) experience and track record of the technology supplier;(iv) extent to which the capital cost is competitive; (v) financing arrangements in place; (vi) raw material linkages; (vii) demand outlook; (viii) competitive environment; and (ix) marketing arrangement and plans. Significantly, the impact of project risk on the rating depends on the scale of projects in relation to the size of assets and cash flows of the issuers existing operations. 5.FINANCIAL RISKThe objective here is to determine the issuers current financial position and its financial risk profile. Some of the aspects analysed in detail in this context are: Operating profitability: The analysis here focuses on determining the trend in the issuers operating profitability and how the same appears by peer comparison. Gearing: The objective here is to ascertain the level of debt in relation to the issuers own funds and is viewed in conjunction with the business risks that the issuer is exposed to. Debt service coverage ratios: The objective here is to ascertain the adequacy of profit generation in relation to the debt servicing requirements. Working capital intensity: The analysis here involves evaluating the trends in the issuers key working capital Indicators like Receivables, Inventory, and Creditors, again with respect to peers. Cash flow analysis: Cash is required to service obligations. Cash flows reflect the sources from which cash is generated and its deployment. Analysed here are the trends in the issuers Funds Flow from Operations (FFO) after adjusting for working capital changes, the Retained Cash Flows, and the Free Cash Flows after meeting debt repayment obligations and capital expenditure needs. The cash flow analysis also helps in understanding the external funding requirement that an issuer has, to meet its maturing obligations. Foreign currency related risks: Such risks arise if an issuers major costs and revenues are denominated in different currencies. Accounting quality: Here, the Accounting Policies, Notes to Accounts, and Auditors Comments that are part of the Annual Report are reviewed. Any deviation from the Generally Accepted

Accounting Practices is noted and the financial statements of the issuer are adjusted to reflect the impact of such deviations. Contingent liabilities/Off-balance sheet exposures: In this case, the likelihood of devolvement of contingent liabilities/off-balance sheet exposures and the financial implications of the same are evaluated. Financial flexibility: The issuers financial flexibilityas reflected by it unutilised bank/credit limits, liquid investments, and the nature of its relationship with banks, financial institutions and other intermediariesis assessed. 6. Strength of Promoters/Management QualityAll debt ratings necessarily incorporate an assessment of the quality of the issuers management, as well as their strengths/weaknesses. 7. Capital StructureThey see the historic, present and projected capital structure pattern Debt to Equity composition. 8. Financial FlexibilityThey take a look at the flexibility of planned financial needs (dividend levels, acquisitions), their ability to raise additional finance under stress, Back up and stand by lines of credit and lastly their ability to attract capital. 9. Future Cash FlowSince the prime objective of the rating exercise is to assess the adequacy of the issuers debt servicing capability, ICRA draws up projections on the likely financial position of the issuer under various scenarios. These projections are based on the expected operating and financial performance of the issuer, the outlook for the industry concerned and the issuers medium/long-term business plans. After this, these findings are presented to the seniors of CRA who passes it onto the final authority (rating committee) for assigning ratings. This is the only part where the issuer does not participate directly. This decision is communicated to the client and kept confidential even if the rating was rejected. Once the client accepts the rating, the CRA disseminates it through printed reports to the public

Rating Symbols
To distinguish the credit quality of the instruments or borrower, different symbols have been used by different rating agencies. The symbols indicate highest safety to highest risk. The symbols used by CRISIL, ICRA and CARE for different instruments are given in separate tables.

Rating symbols for long term debt instruments

SL.NO. CRISIL ICRA CARE SIGNIFICANCE 1 AAA LAAA CARE AAA Highest safety 2 AA LAA CARE AA High safety 3 A LA CARE A Adequate safety 4 BBB LBBB CARE BBB Moderate safety 5 BB LBB CARE BB Inadequate safety 6 B LB CARE B Risk phone 7 C LC CARE C Substantial risk 8 D LD CARE D Default Note: long term debt instruments include debentures, bonds and preference shares

Rating symbols for medium term debt instruments

SL.NO CRISIL ICRA CARE 1 FAAA MAAAMB CARE AAA 2 FAA MAA CARE AA 3 FA MA CARE A 4 FB MB CARE BBB 5 CARE BB 6 CARE B 7 FC MC CARE C 8 FD MD CARE D Note: medium term instruments refer to fixed deposits only SIGNIFIANCE Highest safety High safety Adequate safety Inadequate safety Inadequate safety Inadequate safety Risk prone Default

Rating symbols for short term debt instruments

CRISIL ICRA CARE P1 A1 PR-1 P2 A2 PR-2 P3 A3 PR-3 P4 A4 PR-4 P5 A5 PR-5 Note: short term debt instruments include commercial papers only. SIGNIFICANCE Highest safety High safety Adequate safety Risk prone Default