Credit Rating

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 Meaning of Credit Rating
• A credit rating evaluates the credit worthiness of a debtor, especially a business
(company) or a government. It is an evaluation made by a credit rating agency of
the debtor’s ability and willingness to pay back the debt and the likelihood of
default.

• Credit ratings are determined by credit ratings agencies. Rating agency’s evaluate
qualitative and quantitative information for a company or government; including
non-public information obtained by the credit rating agencies analysts. Credit rating
is for an instrument not for the company as a whole

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 Meaning of Credit Rating
•Credit ratings are not based on mathematical formulas.
•Instead, credit rating agencies use their judgment and experience in giving a rating to a
particular company or government.
•The credit rating is used by individuals and entities to understand the likelihood that the
government/company will repay its obligations.
•Credit rating is a rating agency’s opinion about the company’s credit worthiness.
•A poor credit rating indicates that the company or government has a high risk of
defaulting.
•A good credit rating signifies that the company or government has ability to repay its
obligations with the cash flows

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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.
• The rating is specific to the instrument not to the company as a whole.
• It is not measure factors such as: liquidity risk, pre-payment risk, interest rate risk, risk of
secondary market loss, or exchange loss risk the issuer

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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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 NEED FOR CREDIT RATING
■ It is necessary in view of the growing number of cases of defaults in payment of interest
and repayment of principal sum borrowed by way of fixed deposits, issue of debentures
or preference shares or commercial papers.

■ Maintenance of investor’s confidence, since defaults shatter the confidence of investors

in corporate debt instruments.

■ Motivate savers to invest in industry and trade.

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 OBJECTIVES OF CREDIT RATING
The main objective is to provide superior and low cost info to investors for taking a decision
regarding risk return trade off, but it also helps to market participants in the following ways:

■ Improves a healthy discipline on borrowers,

■ Helps regulatory authorities, etc., in discharging their functions related to debt issues,
■ Encourages greater information disclosure, better accounting standards and improved
financial information (helps in investors protection),
■ May reduce interest costs for highly rated companies,
■ Acts as a marketing tool

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 TYPES OF RATINGS
• SOVEREIGN CREDIT RATING
A sovereign credit rating is the credit rating of a sovereign entity, i.e., a national
government. 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.

“Moody's rating on India stands revised to Baa3 from Baa2, with a negative outlook. It

still remains investment grade”

• SHORT TERM RATING

A short-term rating is a probability factor of an individual going into default within a
year. This is in contrast to long-term rating which is evaluated over a long timeframe. In
the past institutional investors preferred to consider long-term ratings. Nowadays, short-
term ratings are commonly used. 9
• CORPORA TE CREDIT RA TINGS
Credit rating is usually of a financial instrument such as a bond, rather than the
whole corporation and have letter designations such as A, B,C.
The Standard & Poor's rating scale is as follows, from excellent to poor: AAA,
AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, BB+, BB, BB-, B+, B, B-, CCC+,
CCC, CCC-,CC, C, D.
Anything lower than a BBB- rating is considered a speculative or junk bond. 10
 THE CREDIT RATINGS MEANING

The table below summaries the meanings of the comparative ratings of the three major
credit rating companies.
Moody’s S&P Fitch Meaning

(Highest quality; EXTREMELY STRONG

Aaa AAA AAA
capacity to meet financial obligations.)

Aa1 AA+ AA+ (High quality; VERY STRONG capacity

Aa2 AA AA to meet financial obligations. It differs

from

Aa3 AA- AA- the top-line rating only in small

degree.)
(High quality; STRONG capacity to
A1 A+ A+
meet financial obligations

but is somewhat more susceptible to

A2 A A the adverse effects
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 of changes in circumstances and economic
A3 A- A-
conditions.)

(Medium grade; ADEQUATE

Baal BBB+ BBB+ capacity to meet financial obligations

Baa2 BBB BBB but adverse conditions or

likely to lead to a weakened

Baa3 BBB- BBB- capacity to meet financial commitments.)

Bal BB+ BB+ (Lower medium grade; LESS VULNERABLE

but faces major
ongoing uncertainties and
Ba2 BB BB exposure to adverse conditions which

Ba3 BB- BB- could lead to inadequate capacity to meet

financial commitments.)

(Low grade; MORE

Bl B+ B+ VULNERABLE and adverse business,

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 financial, or economic
B2 B B conditions will likely impair its
capacity

B3 B- B- or willingness to meet financial

commitments.)

(Poor quality; CURRENTLY VULNERABLE and

Caa CCC CCC dependent upon favourable
conditions to meet
commitments.)

(Poor quality; CURRENTLY

Ca CC CC
HIGHLY-VULNERABLE.)

(CURRENTLY HIGHLY-
C C VULNERABLE to nonpayment.)

(FAILED to pay one or more of

C D D
its financial obligations.)

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 BENEFITS OF CREDIT RATING
To the investors
■ Helps in Investment Decision :
• Credit rating gives an idea to the investors about the credibility of the issuer company, and
the risk factor attached to a particular instrument.
• So the investors can decide whether to invest in such companies or not.
• Higher the rating, the more will be the willingness to invest in these instruments and visa-
versa.
■ Benefits of Rating Reviews :
• The rating agency regularly reviews the rating given to a particular instrument. So, the
present investors can decide whether to keep the instrument or to sell it.

■ Assurance of Safety :
• High credit rating gives assurance to the investors about the safety of the instrument and
minimum risk of bankruptcy.
• The companies which get a high rating for their instruments, will try to maintain healthy
financial discipline. This will protect them from bankruptcy. So the investors will be safe.

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 BENEFITS OF CREDIT RATING
■ Easy Understandability of Investment Proposal : The rating agencies gives rating symbols to the
instrument, which can be easily understood by investors. This helps them to understand the investment
proposal of an issuer company. For e.g. AAA (Triple A), given by CRISIL for debentures ensures
highest safety, whereas debentures rated D are in default or expect to default on maturity.
■ Choice of Instruments : Credit rating enables an investor to select a particular instrument from many
alternatives available. This choice depends upon the safety or risk of the instrument.
■ Saves Investor’s Time and Effort : Credit ratings enable an investor to his save time and effort in
analyzing the financial strength of an issuer company. This is because the investor can depend on the
rating done by professional rating agency, in order to take an investment decision. He need not waste
his time and effort to collect and analyse the financial information about the credit standing of the
issuer company.
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 BENEFITS OF CREDIT RATING
To the company
■ Improves Corporate Image : Credit rating helps to improve the corporate image of a
company. High credit rating creates confidence and trust in the minds of the investors about
the company. Therefore, the company enjoys a good corporate image in the market.
■ Lowers Cost of Borrowing : Companies that have high credit rating for their debt
instruments will get funds at lower costs from the market. High rating will enable the
company to offer low interest rates on fixed deposits, debentures and other debt securities.
The investors will accept low interest rates because they prefer low risk instruments. A
company with high rating for its instruments can reduce the cost of public issue to raise funds,
because it need not spend heavily on advertising for attracting investors.

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 BENEFITS OF CREDIT RATING
■ Wider Audience for Borrowing : A company with high rating for its instruments can
get a wider audience for borrowing. It can approach financial institutions, banks,
investing companies. This is because the credit ratings are easily understood not only by
the financial institutions and banks, but also by the general public.
■ Good for Non-Popular Companies : Credit rating is beneficial to the nonpopular
companies, such as closely-held companies. If the credit rating is good, the public will
invest in these companies, even if they do not know these companies.
■ Act as a Marketing Tool : Credit rating not only helps to develop a good image of the
company among the investors, but also among the customers, dealers, suppliers, etc.
High credit rating can act as a marketing tool to develop confidence in the minds of
customers, dealer, suppliers, etc.
■ Helps in Growth and Expansion : Credit rating enables a company to grow and
expand. This is because better credit rating will enable a company to get finance easily
for growth and expansion

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 DEMERITS OF CREDIT RATING
■ Possibility of Bias Exist : The information collected by the rating agency may be subject
to personal bias of the rating team. However, rating agencies try their best to provide an
unbiased opinion of the credit quality of the company and/or instrument. If not, they will
not be trusted.
■ Improper Disclosure May Happen : The company being rated may not disclose certain
material facts to the investigating team of the rating agency. This can affect the quality of
credit rating.
■ Impact of Changing Environment : Rating is done based on present and past data of the
company. So, it will be difficult to predict the future financial position of the company.
Many changes take place due to changes in economic, political, social, technological, legal
and other environments. All this will affect the working of the company being rated.
Therefore, rating is not a guarantee for financial soundness of the company.

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 DEMERITS OF CREDIT RATING

■ Problems for New Companies : There may be problems for new companies to collect funds
from the market. This is because, a new company may not be in a position to prove its
financial soundness. Therefore, it may receive lower credit ratings. This will make it difficult
to collect funds from the market.

■ Downgrading by Rating Agency : The credit-rating agencies periodically review the ratings
given to a particular instrument. If the performance of a company is not as expected, then the
rating agency will downgrade the instrument. This will affect the image of the company.

■ Difference in Rating : There are cases, where different ratings are provided by various
rating agencies for the same instrument. These differences may be due to many reasons. This
will create confusion in the minds of the investor.
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 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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 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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 TOP CREDIT RATING AGENCIES

OTHER AGENCIES : TOP AGENCIES :

•A. M. Best (U.S.), •Dun & Bradstreet
•Baycorp Advantage (Australia) • Moody’s
• Egan-Jones Rating Company (U.S.)
•Global Credit Ratings Co. (South Africa)
•Standard & Poor’s
•Levin and Goldstein(Zambia) •Fitch Ratings
•Agusto& Co(Nigeria)
• Japan Credit Rating Agency, Ltd. (Japan).
•Rapid Ratings International (U.S.)
•Credit Rating Information and Services
Limited(Bangladesh

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 CREDIT RATING AGENCIES IN INDIA :

• Credit Rating Information Services of India Limited (CRISIL)

• Investment Information and Credit Rating Agency of India
(ICRA) Limited
• Credit Analysis and Research (CARE) Limited
• Acuite Ratings & Research (earlier SMERA Ratings Limited)
• Brickwork Ratings India Private Limited
• India Ratings and Research Pvt. Ltd.
• Infometrics Valuation and Rating Pvt. Ltd.

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 CRISIL
• The first rating agency ‘Credit Rating Information Services of India
Ltd. , CRISIL, was promoted jointly in 1987 by the ICICI and the
UTI. Other shareholders included ADB, LIC, HDFC Ltd, General
Insurance Corporation of India and several other foreign and Indian
Banks.
• It pioneered the concept of credit rating in the country and since then
has introduced new concepts in credit rating services and has
diversified into related areas of information and advisory activities.
• It became public in 1993.
• In 1996, it formed a strategic alliance with S&P rating group.

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 Services offered by CRISIL
• Credit Rating Services
• Advisory Services
• Credibility first rating and evaluation Services
• Training Services

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 Credit Rating Services(CRS)
• The principle function of CRISIL is to rate mandated debt obligations of Indian
Companies chit fund, real estate developers, LPG Kerosene dealers, NBFC, Indian
states and so on.
• Rating of debt obligations:
- Debt obligation includes rupee denominated credit instruments like debentures,
preference shares, deposits, CD’s commercial papers and a structured obligations
of manufacturing, finance companies, banks, financial institutions etc.
- It ensures stable and healthy growth of capital market by offering credit rating
which is widely acceptable. It provides increased disclosures, better accounting
standards and improved financial information to the users.
- It reduces cost of issue by direct mobilization of resources.
- It protects the interest of investors by constantly monitoring the results of rated
companies.

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• Rating of structured obligations:
— It reflects CRISIL opinion regarding the capacity and willingness of the company to
make timely payments of financial obligations on rated instruments.
• Rating of real estates developers:
— CRISIL has developed framework for rating of real estate projects. Such rating helps
investors to identify their investment options
— The rating is expected to help developers mobilize funds for their projects.
— The methodology assesses a project in terms of project risk factors and developer’s risk
factors.

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Bond Fund ratings:
— The rating is an opinion of the quality of bond funds underlying
portfolio holdings. They mainly focus on fixed income securities.
— The rating methodology takes into account the following factors i.e.,
credit associated with the securities, the systems and procedures followed
by the funds and management quality and expertise.
Bank loan rating :
— The creditworthiness of bank’s borrower is assessed offering comments
on the likelihood of repayment of loans.
— The methodology considers the borrowers underlying assets liquidity
and risk management initiative and for NBFC quality of assets , loans and
investment.

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 Collective investment schemes:
This covers rating of collective investment schemes offering opinion on the degree
of certainty of the scheme to deliver the assured returns in terms of cash as
mentioned in the offer document
• Grading of health care institutions:
The grading for healthcare institutions is an opinion on the relative quality of
health care delivered by the institutions to the patients. Grading is done taking into
account facilities, quality , consistency in delivering the service etc. Flowing are the
grades given Grade A( Very good quality), Grade B (Good Quality) , Grade C
(Average Quality) and Grade D( Poor Quality)

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 CRISIL Advisory Services (CAS)
• The CAS offers consulting services that aim at identifying and mitigating risk. The main
focus of these services is transaction and policy level assignments in the area of energy,
transport, banking and finance disinvestment, privatization and valuation.
— Energy group services: it offers advisory services to companies engaged in energy
sector like power, coal, oil and gas. The policy level assignments Include aspects
like sector reforms and structuring, regulatory framework privatization, corporate
plan fuel related services.
— Transaction level assignment include project scoping and structuring, bid process
management, financial viability analysis of projects, risk identification and analysis
and structuring of project contacts, security package, structuring and analysis.

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• Transport and urban infrastructure group services: It provides financial advisory services
to transport and infrastructure service provider.
— Policy level assignments include advice on transport sector privatization policy of
state ports, development of risk identification allocation, long term sector plans and
state role.
— Transaction level assignments include financial viability analysis, project
structuring, bid process management, negotiation of terms with successful bidders
— Privatization and disinvestment group: this group renders advisory services to
central, state governments, public sector enterprises and private sector entities
interested in participating in privatization program, these services cover 3 aspects
policy level, enterprise level and reforms and restructuring.

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• Banking and finance group:
CRISIL offers a wide range of services covering restructuring and business
reengineering, credit management, investment management and portfolio
insurance, equity valuation, resource mobilization studies and financial
feasibility studies.
• Capital Market Group:
This group provides customized research and advisory assistance to meet
specific transactional and strategic requirements of clients. It offers
services like diagnostic evaluation for valuation of Indian partner of a
foreign asset management company, technical assistance to AMFI,
portfolio evaluation and portfolio analysis for leading mutual funds,
composite performance ranking of domestic mutual funds, assistance to
government for the development of India’s financial sector.

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 Symbol Description (with regard to the likelihood of meeting the debt
(Rating category). obligations on time)

AAA Highest Safety

AA High Safety

A Adequate Safety

BBB Moderate Safety

BB Inadequate Safety

B High Risk

C Substantial Risk

D Default

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 ICRA Ltd
• Information and Credit Rating Services (ICRA) has been promoted by IFCI Ltd as the main
promoter and started operations in 1991.
• Other shareholders are UTI, Banks, LIC, GIC, Exim Bank, HDFC and ILFS.
• It provides Rating, Information and Advisory services ranging from strategic consulting to
risk management and regulatory practice.
• The main objectives of ICRA are to assist investors both individual and institutional in
making well informed decisions
• To assist issuers in raising funds from a wider investor base.
• To enable banks, investment bankers, Brokers in placing debt with investors.
• To provide regulators with market driven systems to encourage the healthy growth of
capital markets.
• It provides rating services, information services and advisory services.
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 Rating services
• ICRA rates debt instruments issued by manufacturing companies, commercial
banks, NBFCs, financial institutions, PSUs and municipalities.
• The instruments rated by it include bonds/ debentures, fixed deposits, commercial
papers and certificate of deposit. It also rates structured obligations in accordance
with the terms of the structure based on risk assessment of the instrument . It rates
sector specific debt obligations issued by power, telecom and infrastructure
companies.
• It also provides corporate governance rating , rating of claims
paying ability of insurance companies, credit assessment of large medium and small
scale companies to obtain assistance from banks, FIs. It also provides services of
general assessment of companies. 35
 Information services
• The information services division of ICRA focuses on providing authentic data
and value added products used by intermediaries, financial institutions, banks,
asset managers, institutions and investors.
• Value added services include equity grading providing a critical input on a
company's earning prospects and inherent risks in decision making process of
equity investors and equity assessment.
• Other services include corporate reports, equity assessment, mandate based
studies (customized research) and sector/industry specific publication.

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 Advisory services
• The advisory services division of ICRA offers wide ranging management advisory services.
Under advisory services ICRA provides its understanding on the business processes and
relevant organizational issues to different players of financial markets such as investors,
issuers, regulators, intermediaries and media.
• The advisory services include 1.strategic consulting/ strategic practice 2. risk management
(credit risk, market risk and operations risk) 3. regulatory practice 4 transaction practice 5.
information( content services).
• It focuses on sectors like banking and financial services, infrastructure sector,
manufacturing and service sector, government and regulatory authorities.

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 CARE Ltd.
• Credit Analysis and Research Ltd or CARE is promoted by IDBI jointly with Financial
Institutions, Public/Private Sector Banks and Private Finance Companies.
• It commenced its credit rating operations in October, 1993 and offers a wide range of
products and Services in the field of Credit Information and Equity Research.
• It also provides advisory services in the areas of securitization of transactions and
structuring Financial Instruments.
• It offers services like 1. Credit rating of debt instruments 2.
Advisory services like securitization transactions, structuring financial instruments, financing
infrastructure projects and municipal finances 3. Information services like providing
information to companies, industry and businesses. 4. Equity research 38
 CREDIT RATING METHODOLOGY

Consist of 4 areas:

■ Business analysis- covers an analysis of industry risk, market position in the country, operating
efficiency of the company and legal position.
■ Financial Analysis- analysis of accounting quality, earnings protection, cash flow adequacy
and financial flexibility.
■ Management Evaluation- study of track record of the management’s capacity to overcome
adverse situations, goals, philosophy and strategies.
■ Fundamental analysis- analysis of liquidity management, asset quality, profitability and
interest and tax sensitivity.

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 CREDIT RATING METHODOLOGY
Steps or process:-
■ Information is collected and then analysed by a team of professionals in an agency.
■ If necessary, meetings with top management suppliers and dealers and a visit to the
plant of proposed sites are arranged to collect additional data. This team of
professionals submit their recommendations to the rating committee.
■ Committee discusses this report and then assigns rating.
■ Rating assigned is then notified to the issuer and only on his acceptance, rating is
published.
■ Assures confidentiality of information.
■ Once the issuer decides to use and publish the rating, agency has to continuously
monitor it over the entire life of instrument, called surveillance.

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 Credit rating for financial service sector
• When rating debt instruments of financial institutions, banks, NBFCs in
addition to the financial analysis and management evaluation. The following
factors are considered:
• Regulatory and competitive environment
• Fundamental analysis
• Capital adequacy
• Asset quality
• Liquidity management
• Profitability and financial position
• Interest and tax sensitivity
 Credit Rating of Indian States
• Rating of the states by the CRISIL represents a landmark in the diversification of the
rating Business in the country.
• It has already rated several states.

• While assessing a state, CRISIL considers two basic factors:

• The Economic Risk; and
• The Political Risk
 Economic Risk
• Economic structure of the state and its finances
• Macroeconomic performance
• Infrastructure
• Sector studies
• Whether revenue and expenditure patterns are sustainable.
• Deficit Management
• Degree of dependence on Central support
• Tax policy of the state
• Performance of Public sector undertakings and their effect on the state’s finances.
 Political Risk
• Relations between the state and the Centre and its impact on transfer of
resources as well as centre’s influence on political stability in the state.
• Various political parties in the state, their economic policies and their effect
on the state’s policies.
• Quality of the current leadership and administration
• Ability of the Government to take decisions that are politically difficult.
 SEBI Guidelines on Credit Rating

■Credit Rating Agencies should be SEBI Registered.

■ A registration fee of Rs. 50,000 should be paid to SEBI. ■SEBI
Registration is valid for a Period of 3 Years.
■ Minimum Net worth of Rs 5 Crore is needed for a Credit Rating
Agency or an Undertaking to Enhance the Net worth with in 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. 45
 Eligibility Criteria
• Is set up and registered as a company
• Has specified rating activity as one of its main objects in its
Memorandum of Association.
• Has a minimum Net worth of Rs 5 Crore.
• Has adequate Infrastructure.
• Promoters have professional competence, financial soundness and a
general reputation of fairness and integrity in Business transactions , to
the satisfaction of SEBI.
• Has employed persons with adequate professional and other relevant
experience, as per SEBI directions.
 Agreement with the client

• The CRA should enter into a written agreement with each client
containing
o Rights and liabilities of each party with respect to rating of securities.
o Fee charged.
o A periodic review of the rating during the tenure.
o Clients agreement to cooperate and provide true, adequate and timely
information.
o Disclosure by CRA to client regarding the rating assigned.
o Clients agreement to disclose the rating assigned in the offer document for
the last 3 years .
 IPO Grading
• SEBI has made grading of IPOs compulsory, effective from May 1, 2007.It
shall be mandatory to obtain grading from at least one credit rating agency.
• 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 : Poor fundamentals
• IPO grade 2 : Below Average fundamentals
• IPO grade 3 : Average fundamentals
• IPO grade 4: Above Average fundamentals
• IPO grade 5: Strong fundamentals

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 Conclusion
• Credit ratings thus can help and to make markets more efficient by putting
all lenders and investors on more equal footing, thereby minimizing
variations in returns that can arise from differences in the ability to make
sound credit judgments.
• Ratings are a type of information, in the form of independent opinions
about the creditworthiness of issuers and securities. They fulfil their role by
adding to the mix of information that investors and lenders can use when
analyzing and trading securities.

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