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
Investors
uses CREDIT RATING ?
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+,
AA- etc.)
• 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