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7/30/2019 Credit Rating.1 1

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Credit Rating


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Credit rating is an assessment of the capacity ofan issuer of debt security, by an independentagency, to pay interest and repay the principalas per the terms of issue of debt.

A rating agency collects the qualitative as wellas quantitative data from a company which hasto be rated and assesses the relative strengthand capacity of company to honour itsobligations contained in the debt instrumentthrough out the duration of the instrument. Therating given is based on an objective judgmentof a team of experts from the rating agency.


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The ratings are expressed in code numberwhich can be easily comprehended even by thelay investors. The ratings are the quickest way ofunderstanding a companys financial standingwithout going into the complicated financialreports.

Credit rating is only a guidance to the investorsand not a recommendation to a particular debtinstrument.


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The important element for investment decision-making in debt security are:

Yield to maturity

Risk tolerance to investor

Credit risk of the security


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A debt rating is not a one- time evaluation of

credit risk, which can be regarded as valid for

the entire life of the security. It is an on going

appraisal. Changes in dynamic world ofbusiness may imply a change in the risk

characteristics of the security. Hence, debt rating

agencies monitor the business and financial

conditions of the issuer to determine whethermodification in rating is warranted.


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Functions of Credit Ratings

Superior Information- Rating by an independent

and professional firm offers a superior and more

reliable source of information on credit risk for

three inter- related risks: It provides unbiased opinion

Due to professional resources, a rating firm has

greater ability to assess risks.

It has access to lot of information which may not

be publicly available.


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Low- cost Information- A rating firm gathers,

analyses, interprets and summarizes complex

information in a simple and readily understood

format for wide public consumption represents acost- effective arrangement.


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Basis for a proper Risk- Return Trade- off- If

debt securities are rated professionally and if

such ratings enjoy widespread investor

acceptance and confidence, a more rational risk-return trade- off would be established in the

capital market.


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Healthy discipline on Corporate Borrowers-

Public exposure has healthy influence over the

management of issuer because of its desire to

have a clear image.


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Formulation of Public Policy Guidelines on

Institutional Investment- The public policy on the

kinds of securities that are eligible for inclusion

in different kinds of institutional portfolios can bedeveloped with great confidence if securities are

rated professionally by independent agencies.


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Classification of Credit Rating

Debenture and bond rating

Equity rating

Fixed deposit and certificate of deposit rating

Commercial paper rating

LPG/ Kerosene dealers/ Firms rating Chit funds rating

Real estate developers rating

Banks rating Rating of structured obligations

Sovereign rating

Customer rating


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Advantages of Credit Rating


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Advantages to Investors

Assessment of credibility

Risk indicator

Protects against bankruptcy

Easy to understand

Enables quick decisions

Rating surveillance

Other services


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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 outjudiciously and impartially. Hence, it is beneficial

to the investor to understand the credibility of the

issuing company.


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Risk indicator- Investors risk perception largely

depend on the reputation of the names of thepromoters or the collaborations but evaluation

based on name recognition cannot be an effective

substitute for systematic risk evaluation. A

reputed name cannot assure success or be freefrom default risk. However, a credit rating agency

rates the instrument after analyzing the various

aspects of the company. All the investors may not

possess the required knowledge and informationfor credit evaluation. The investors can identify

the risk associated with them with the symbols

assigned to the instruments by the credit rating

agency.


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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 indicated a safeinvestment.


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Easy to understand- The rating is given in the

forms of symbols. Once the symbols are clearly

explained, it is easy to understand and use

them. No analytical knowledge is required tounderstand the rating.


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Enables quick decisions- An investor can take

quick decision based upon the rating. There is

no need for the investor to understand and use

them. No analytical knowledge is required tounderstand the rating.


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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. Investor canmake changes in portfolio mix.


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Portfolio diversification- Rating is not only helpful

to the individual/ small investors but also to an

organized institutional investor. Large investors

may use credit rating for portfolio diversificationby selecting appropriate instruments from a

broad spectrum of investment options.


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Rating surveillance- Rating is not a one- time

business. It is a continuously process. Rating

agencies continually watch the financial strength

and other related factors of the company. If theyfind that the situation is not up to the mark, they

downgrade the instruments and give a warning

signal to the investor and the company. The

investor has to reorganize his portfolio and thecompany had to look for alternate ways for

strengthening its credibility.


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Other services- The rating agencies conduct

research studies and provide industry reports,

seminars and open access to analysts of the

agencies for discussion.


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Advantages to the Issuers

Lowers the cost of borrowing

Widens investor base

Fosters a better image

Induces self discipline

Lowers the cost of issue

Motivates growth


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Lowers the cost of borrowing- The higher rating

for safety provided by the rating agencies builds

the investors confidence in the payment of

principal and interest. The issuing company cancapitalize on this by lowering the rate of interest.

The investors who are interested in the safety of

the instrument do not mind the marginal decline

in the rate of interest. The issuing companycould borrow at a low rate of interest as well.


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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 opinions of the rating agencybuild up investors confidence which could

enable the issuers to raise funds in various

media.


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Fosters a better image- The financial and

managerial performance of an issuer is analyzed

and ratings are assigned to their instruments.

Rating creates a better image for an issuer. Anissuer himself improves his image when he has

to get the rating. Hence, it builds a better image

for the rated instrument.


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Induces self discipline- Rating requires the

disclosure of accounting system, financial

reporting and management pattern. This

disclosure imposes self discipline on thefunctioning of the company. An issuer tries to

maintain the standard of rating attained by them

or to improve the rating which would help them

to raise more funds.


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Lowers the cost of issue- A higher rating makes

it more accessible to the investor. The rating

itself speaks volumes. There is no need to have

wide publicity or adopt other ways of publicitylike organizing an investors meet or brokers

meet. This reduces the cost of the public issue.

Further, rating could be used as a benchmark

for issue pricing.


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Motivates growth- Rating instills a feeling of

confidence and encourages the entrepreneurs to

undertake new projects and expand the existing

projects. With a higher credit rating, a companycan mobilize the needed funds from the public

and financial institutions.


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Advantages to the Intermediaries

It enables proper planning, pricing, underwriting

and placement of the issues. Brokers and

dealers could use ratings to monitor their risk

exposures. This saves their time, cost, energy and

manpower in analyzing the investment risk.

Rating is also used in securitization of assets

and helps the special purpose vehicle to

repackage the assets.


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Rating Process

Primary StagePrimary Stage Fact Findings & AnalysisRating

StageFinal

Stage

1. Rating

request

2. Assigningrating

team

1. Preview

Meeting

2. Rating

Committee

Meeting &Rating

1.Communication

& acceptance

2. Surveillance

1. Collection of

information

2. Meetings & Plant

visits

3. Preparation of

reports


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IPO Grading

IPO grading is the grade assigned by a Credit

Rating Agency registered with SEBI, to the initial

public offering (IPO) of equity shares or any

other security which may be converted into orexchanged with equity shares at a later date.

The grade represents a relative assessment of

the fundamentals of that issue in relation to the

other listed equity securities in India.


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IPO grading is generally assigned on a five-point

point scale with a higher score indicating

stronger fundamentals and vice versa as below:

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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IPO grading has been introduced as an endeavor

to make additional information available for theinvestors in order to facilitate their assessment of

equity issues offered through an IPO.

IPO grading can be done either before filing the

draft offer documents with SEBI or thereafter.

However, the Prospectus/Red Herring

Prospectus, as the case may be, must containthe grade/s given to the IPO by all CRAs

approached by the company for grading such

IPO.


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The company desirous of making the IPO is

required to bear the expenses incurred for

grading such IPO.

IPO grading is not optional. A company whichhas filed the draft offer document for its IPO with

SEBI, on or after 1st May, 2007, is required to

obtain a grade for the IPO from at least one

CRA.


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IPO grade/s cannot be rejected. Irrespective of

whether the issuer finds the grade given by the

rating agency acceptable or not, the grade has

to be disclosed as required under the DIPGuidelines. However the issuer has the option of

opting for another grading by a different agency.

In such an event all grades obtained for the IPO

will have to be disclosed in the offer documents,advertisements etc.


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IPO grading is intended to run parallel to the

filing of offer document with SEBI and the

consequent issuance of observations. Since

issuance of observation by SEBI and the gradingprocess, function independently, IPO grading is

not expected to delay the issue process.


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The IPO grading process is expected to take into

account the prospects of the industry in which

the company operates, the competitive strengths

of the company that would allow it to address therisks inherent in the business(es) and capitalise

on the opportunities available, as well as the

companys financial position.


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The areas listed below are taken into

consideration for arriving at an IPO grade:

Business Prospects & Competitive Position

Industry Prospects

Company Prospects Financial Position

Management Quality

Corporate Governance Practices Compliance and Litigation History

New Projects- Risk & Prospects


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Credit Rating Information Services(CRISIL)

CRISIL, India's first credit rating agency was

floated in year 1988, promoted by the erstwhile

ICICI Ltd, along with UTI and other financial

institutions. A CRISIL rating reflects CRISIL's current opinion

on the relative likelihood of timely payment of

interest and principal on the rated obligation. It is

an unbiased, objective, and independent opinionas to the issuer's capacity to meet its financial

obligations.


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Objectives of CRISIL

To assist both individual and institutional

investors in making investment decisions in fixed

income securities.

To enable corporate to raise large amounts atfair cost from a wide spectrum of investors.

To enable intermediaries in placing their debt

instruments with investors by providing them

with an effective marketing tool.


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The debt obligations rated by CRISIL include:

Non-convertible debentures/bonds/preference

shares Commercial papers/certificates of

deposits/short-term debt

Fixed deposits

Loans

Structured debt


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ICRA

ICRA Limited (formerly Investment Information

and Credit Rating Agency of India Limited) wasset up in 1991 by leading financial/investment

institutions, commercial banks and financial

services companies as an independent and

professional Investment Information and Credit

Rating Agency.

ICRA and its subsidiaries together form the

ICRA Group of Companies (Group ICRA). ICRAis a Public Limited Company, with its shares

listed on the Bombay Stock Exchange and the

National Stock Exchange.


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The international Credit Rating Agency Moodys

Investors Service is ICRAs largest shareholder.

The participation of Moodys is supported by a

Technical Services Agreement, which entailsMoodys providing certain high-value technical

services to ICRA.

ICRA has launched a quarterly publication-

Money and Finance, it contains various articlesthat analyze contemporary developments in the

Indian money and capital markets.


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Objectives

To provide information and guidance to

institutional and individual investors/creditors.

To enhance the ability of borrowers/issuers to

access the money market and the capital

market for tapping a larger volume of resourcesfrom a wider range of the investing public.

To assist the regulators in promoting

transparency in the financial markets.

To provide intermediaries with a tool to improve

efficiency in the funds raising process.


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Credit Analysis and Research Limited

(CARE)

CARE Ratings commenced operations in 1993. It has been set up by the IDBI in collaboration

with some banks and financial institutions.

CARE assists the Disinvestment Commission in

equity valuation of a number of state owned

companies and for suggesting disinvestment

strategies for these companies.

CARE rating undertakes corporate governanceratings, mutual fund credit quality ratings, IPO

grading, claims paying ability rating of insurance

companies, grading of construction entities and

issuer grading.


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Moodys

Moody's Corporation (NYSE: MCO) is the parent

company of Moody's Investors Service, which

provides credit ratings and research covering

debt instruments and securities, and Moody'sAnalytics, which offers leading-edge software,

advisory services and research for credit and

economic analysis and financial risk

management.


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Moody's is an essential component of the global

capital markets, providing credit ratings,

research, tools and analysis that contribute to

transparent and integrated financial markets.

The system of rating securities was originated by

John Moody in 1909. The purpose of Moody's

ratings is to provide investors with a simplesystem of gradation by which future relative

creditworthiness of securities may be gauged.


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Moodys rating symbols are : Aaa Aa A Baa Ba

B Caa Ca C


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Standard & Poor's (S&P)

Standard & Poor's (S&P) is an American

financial services company. It is a division of The

McGraw- Hill Companies that publishes financial

research and analysis on stocks and bonds. It iswell known for its stock market indices, the U.S.-

based S&P 500, the Australian S&P/ASX 200,

the Canadian S&P/ TSX, the Italian S&P/ MIB

and India's S&P CNX Nifty. S&P issues both short-term and long-term credit

ratings.


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Limitations of Rating

Rating does not recommended buying or selling-

A high credit rating should not be considered as

a recommendation for buying or selling. It is not

necessary that if the debt issue of a company

has a Triple A rating, the companys debt isworth investing in. The companys earning and

growth prospect are more important. However,

credit raters are more interested in the

companys solvency and its ability to repay itsdebt, especially during recession.


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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 thecharacteristics of the instrument. An instrument

backed by collateral security will have a higher

rating than the one that is unsecured.


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Possibility of getting different ratings- Credit

rating are opinions of the credit rating agencies

on debt issues of companies. It is quite possible

to get different ratings for the same companyfrom two different agencies and it happens often.


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Review Tag- 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 interimperiod, which might not have been considered

by the rating agencies.


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The absence of widespread branch network ofthe rating agency may limit its skills in rating.

Inexperienced, unskilled or overloaded staff maynot do justice to their job and the resultingratings may not be perfect.

The rating agencies receive a sizeable fee fromthe companies for awarding ratings, a tendencyto inflate the ratings may develop.

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