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CREDIT RATING & ITS IMPORTANCE

Prepared by

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Importance of this session. CREDIT Rating is an important innovation in financial services. Learning will help us to know more about Credit rating methodologies Indepth Knowledge in CREDIT Rating methods has got immense career opportunities

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TOPICS COVERED WHAT IS CREDIT? WHAT IS CREDIT RATING? WHAT CREDIT RATING IS NOT? USES OF CREDIT RATING FOR ISSUERS USES OF CREDIT RATING FOR INVESTORS SEBI GUIDELINES FOR CREDIT RATING AGENCIES CREDIT RATING AGENCIES IN INDIA CRISIL ICRA CARE LONG TERM, SHORT TERM, MEDIUM TERM CREDIT RATINGS

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TOPICS COVERED CREDIT RATING MECHANISM IPO GRADING IMPACT OF CREDIT RATING IN MOVEMENT OF BOND PRICES

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Introduction to Credit Rating

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Introduction to CREDIT Rating What is Credit ?

Provision of resources by one party to another party. The second party does not reimburse the first party immediately, and instead arranges either to repay or return the resources at a later date. It is any form of deferred payment. The first party is called a creditor, also known as a lender, while the second party is called a debtor, also known as a borrower. Credit is important since Individuals and Corporations with poor credit will have difficulty finding financing and will most likely have to pay more due to the risk of default

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What is a credit rating? A credit rating is an opinion on the relative degree of risk associated with timely payment of interest and principal on a debt instrument. A Credit rating assesses the Credit worthiness (ability to pay interest and principal in time) of an Individual, Corporation or even a country. A simple alphanumeric symbol is used to convey a credit rating. Credit Ratings are calculated from Financial History, Current Assets and Liabilities of a firm and History of borrowing and repayment. Tells a lender or an investor the probability of default by borrower (not being able to pay back a loan) A poor credit rating indicates a high default risk.

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What credit rating is NOT? Not a recommendation to buy, hold or sell a debt instrument A rating is one of the inputs that is used by investors to make an investment decision Rating do not comment on the return being offered on a debt instrument nor are they offered as guarantees or protections against default. They are opinions only Rating is specific to the instrument & is not the rating of the issuer Ratings are not intended to measure factors such as liquidity risk, pre-payment risk, interest rate risk, risk of secondary market loss, or exchange loss risk

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What credit rating is NOT?

A credit rating is not an assurance of repayment of the rated instrument. It is possible that some highly rated issuers could default. In the US, some instruments rated at even 'AAA' levels have defaulted. However, such defaults would be less frequent amongst highly rated instruments than amongst instruments with lower ratings

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Uses of Credit Rating

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Uses to Issuers of Securities Good Credit rating decreases the cost of borrowed capital. Companies may be able to borrow at a lower interest owing to their High Credit rating. Good Credit rating serves as an Additional Certification Increase the investor population since Investors prefer safety first. Merchant Bankers Job Made easy since marketing of Debt Instruments with High Rating is Easy Foreign Collaborations made easy Benefits the industry as a whole

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Uses to Investors Low Cost Information Quick Investment Decision Independent Investment Decision Can select or distinguish Risky assets from Safety ones Continuous monitoring by CREDIT Rating agencies gives Investors a knowledge about the company throughout the life time of Security and hence he can redeem the security if the rating changes.

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Credit Rating Agencies

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What is a Credit Rating Agency? Independent Agency who assess the capacity of the issuer of the debt security to pay interest and repay the principal as per the terms and conditions. They collect a fee from the Issuers for rating their Debt Securities They rate an instrument based on parameters like business risk market position operating efficiency adequacy of cash flows financial risk, financial flexibility, and management and industry environment.

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What is a Credit Rating Agency? Credit Rating is not one time evaluation of Credit Risk. Agencies continuously monitor the Performance of the company till the maturity of Particular Security. This is known as SURVEILLANCE. Changes affecting the company are taken into account and the rating, if necessary, is changed, upwards or downwards. In other words, a rating is valid during the life of the instrument unless is changed

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SEBI Guidelines on Credit Rating

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Important SEBI Guidelines CREDIT Rating Agencies should be SEBI Registered Minimum Networth of Rs 5 Crore is needed for a Credit Rating Agency or an Undertaking to Enhance the Networth with in a period of 3 Years SEBI Registration is valid for a Period of 3 Years. NO Company shall make a Public Issue or rights issue of Debt Instruments, unless Credit Rating is obtained from at least one Credit Rating Agency. SEBI has made grading of IPOs compulsory, effective May 1 2007.It shall be mandatory to obtain grading from at least one credit rating agency

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IPO Grading IPO grading is the grade assigned by a Credit Rating Agency (CRAs) registered with SEBI, to the IPO of equity shares or any other security which may be converted into or exchanged with equity shares at a later date. IPO grade 1 IPO grade 2 IPO grade 3 IPO grade 4 IPO grade 5 Poor fundamentals Below Average fundamentals Average fundamentals Above average fundamentals Strong fundamentals

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Credit Rating Mechanism

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Credit Rating Mechanism

Credit Risk

Industry Risk
Industry Characteristics Industry Financials

Business Risk
Market Position Operating Efficiency

Management Risk
Track Record

Financial Risk
Existing Fin. Position

Credibility

Future Financial Position Financial Flexibility

Payment Record

Others

Accounting Quality

External factors Scored centrally once in a year

Internal factors Scored for each borrowing.

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Overview of Credit Rating Agencies in India

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CRISIL Credit Rating Information Services Limited CRISIL Floated on Jan 1st 1988 Indias Leading rating Agency and the Fourth largest in the world Jointly Promoted by Standard & poor, National Stock Exchange and other financial Institutions

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CRISIL ratings Description Symbol AAA AA A BBB BB B C D Highest Safety High Safety Adequate Safety Moderate Safety Inadequate Safety High Risk Substantial Risk Default

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CRISIL ratings for Short Term Instruments

This rating indicates that the degree of safety regarding timely payment on the instrument is very strong. This rating indicates that the degree of safety regarding timely payment on the instrument is strong; however, the relative degree of safety is lower than that for instruments rated 'P1'. This rating indicates that the degree of safety regarding timely payment on the instrument is adequate; however, the instrument is more vulnerable to the adverse effects of changing circumstances than an instrument rated in the two higher categories. This rating indicates that the degree of safety regarding timely payment on the instrument is minimal and it is likely to be adversely affected by short-term adversity or less favorable conditions. This rating indicates that the instrument is expected to be in default on maturity or is in default.

P1

P2

P3

P4 P5

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ICRA Investment Information and Credit Rating Agency of India Limited - ICRA An Associate of Moodys Investor Service Second Largest Rating Agency in India Promoted by Leading Banks and Financial Institutions It Provides Rating Services, Advisory Services, Research Services and Economic Research services. ICRA ratings are based on an in-depth study of the industry as also an evaluation of the strengths and weaknesses of the company.

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ICRA will look into the following before rating a security Marketing strategies competitive edge level of technological development operational efficiency competence and effectiveness of management hedging of risks, cash flow, trends and potential liquidity, financial flexibility government policies past record of debt servicing sensitivity to possible changes in business/economy

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ICRA

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ICRA

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ICRA Short Term Ratings

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CARE Credit Analysis and Research Limited Established in 1993 IDBI and Canara Bank are major promoters. IL&FS and other Financial Institutions also hold stake in CARE. Services Offered by CARE are Credit Rating Equity Research Economic Research

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Long /Medium -term instruments (NCD/FD/CD/SO/CP)

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Credit Rating of Debt instruments

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CREDIT RATING AND ITS IMPACT ON BOND PRICE

CASE I Rating Comes Down

AAA rated Security was trading at Rs 100/Coupon 8% P.A Yield of AA rated Sec then was 10% P.A Rating of AAA Security comes down to AA Price of the Security will come down to Rs 80/- so as to yield 10% P.A Investors who bought AAA rated Security at Face Value would incur a Capital Loss of 20%
RATING COMES DOWN BOND PRICE COMES DOWN

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CREDIT RATING AND ITS IMPACT ON BOND PRICE

CASE II Rating Increases

AA rated Security was trading at Rs 100/Coupon 10% P.A Yield of AAA rated Sec then was 8% P.A Rating of AA rated Security becomes AAA Price of the Security will increase by Rs 25/- so as to yield 8% P.A Investors who bought AA rated Security at Face Value would incur a Capital Gain of 25% RATING INCREASES BOND PRICE INCREASES

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