Capital Market Analysis and Corporate Laws Paper 11 CREDIT RATING Date/ Time / version © South Indian Regional Council for ICWAI

CREDIT RATING Credit Rating Comprises of 2 words – Credit and Rating. Credit means Trust in person’s ability and intention to pay or reputation of solvency and honesty. Rating means estimating worth or value of or to assign value to classifying a person’s position with reference to a particular subject matter. Thus, it can be said that credit is as act of assigning value of estimating worth or reputation of solvency and honesty so as to repose trust in a person’s ability and intention to repay. Credit Rating is an expression of opinion through symbols, about credit quality of the issuer of securities of company with reference to a particular instrument. It does not amount to a recommendation to subscribe, purchase, hold or sell that security. It is representative in nature. Credit Rating is only a risk evaluation which is one of the factors in investment decision-making. It does not indicate market risk or forecast future market price. Credit Rating is always a specific evaluation and is done for a particular instrument.  (contd..) .  

CREDIT RATING (contd..) Credit Ratings are simply information. They provide investors with a ready means of measuring the credit risk associated with a particular instrument. Provide a comparative framework, which allows the investor to compare investment opportunities. Ratings are not a guarantee against loss. They are Simply opinion based on careful analysis on the risk of default. Merely a tool to assist in decision- making. Like any other tools, they are meant to be used appropriately, based on particular requirements of risk and return

SCOPE AND NEED FOR CREDIT RATING Throughout the world, credit rating has now become obligation for companies. Since, it is the instrument or security which is rated and not the issuer, the ratings may differ for different instruments issued by the same company. Lack of information about the issuer and the instrument lead to the need for credit rating. Further, more dependence of corporate entities on public debt for project finance and working capital requirements has resulted in a number of debt instruments which from investors protection angle, should be rated. This necessity is felt more under Indian condition where investors lack knowledge and information and act upon the advise of intermediaries who canvass for their self-interest and motivate the investors to make a particular investment.  (contd..)

SCOPE AND NEED FOR CREDIT RATING (contd..) After abolition of the office of the Controller of Capital Issues and repeal of Capital Issues (Control)Act 1947 in 1992, free pricing of securities of companies and liberty to go public without banks or financial institutions stake, credit rating has become the only check for investors. The high levels of default in the U.S. capital markets after the great depression played a crucial role in promoting the growth of the credit rating system. Further impetus for growth came when regulatory agencies began to stipulate that institutions such as Government Pension Funds and Insurance Companies could not buy securities rated below a particular grade. In addition, investors themselves became aware of the rating mechanism and started using ratings extensively as a tool of risk assessment. Merchant bankers, underwriters and other intermediaries (contd..)

SCOPE AND NEED FOR CREDIT RATING (contd..) involved in the debt market also found rating useful for planning and pricing the placement of debt instrument. While the initial need for credit rating came from increasing levels of default, the growing importance of the credit rating in many parts of the world over the last two decades has been a consequence of the following developments:  The increasing role of capital and money market consequent to dis- intermediation increased securitization of borrowing and lending consequent to dis- intermediation Globalization of the credit market the continuing growth of information technology (contd..)

SCOPE AND NEED FOR CREDIT RATING (contd..) the growth of confidence in the efficiency of the market mechanism the withdrawal of Government safety nets and the trend towards privatization The quality of credit rating mainly depends upon Quality of the rating agency Rating elements Quality of the rating agency will depend upon its reputation, professional competence, independent, quality of staff, Government non-interference. Etc.

THE CONCEPT OF CREDIT RATING Ratings, usually expressed in alphabetical or alphanumeric symbols, are a simple and easily understood tool for investor. They enable the investor to differentiate between debt instruments on the basis of their underlying credit quality. The Credit Rating is thus a symbolic indicator of the current opinion of the relative capability of a corporate entity to service its debt obligations in a timely fashion, with specific reference to the instrument being rated. Names of credit rating agencies Investment Information & Credit Rating Agency of India Ltd (ICRA) Credit Rating and Information Services (India) Ltd (CRISIL) Credit Analysis & Research Ltd (CARE) (contd..)

THE CONCEPT OF CREDIT RATING (contd..) Fitch India Pvt Ltd Onida Individual Credit Rating Agency of India Ltd (ONICRA)  

BENEFITS OF CREDIT RATING For Companies / issuers: The market places immense faith in opinion of credit rating agencies. Hence the issuers also depend on their information, which enables the issuers highly rated instruments to access the market even during adverse market conditions.  For Investors: The main purpose of credit rating is to communicate to the investors the relative ranking of the default loss probability for a given fixed income investment in comparison with other related instruments. It is essentially an information service. Credit rating by skilled, competent and credible professionals eliminates or at least minimizes the role of name recognition and replaces it with well-researched and properly analyzed opinions. This method provides a low cost supplement to investors. Large investors use information provided by rating (contd..)

BENEFITS OF CREDIT RATING (contd..) agencies such as upgrades and downgrades and alter their portfolio mix by operating in the secondary market.  For Intermediaries: Merchant Bankers, Underwriters, Brokers and other intermediaries use rating as a guideline for monitoring ‘risk exposures’. Credit Rating is helpful in Planning Pricing Underwriting Placement Book Building (contd..)

BENEFITS OF CREDIT RATING (contd..) Merchant Bankers use Rating also for pre-packaging issues by way of asset securitization and structured obligations For Regulators: Specify rules that restrict entry to the market of new issues rated below a particular grade. Stipulates different margin requirements for mortgage of rated and un-rated instruments and prohibit institutional investors for purchasing or holding instruments rated below a particular level. Credit Rating was made mandatory for issuance of the following instruments As per the regulation of SEBI, public issue of debenture and bonds convertible/redeemable beyond a period of 18 months needed credit rating; it is optional for debt instrument with maturity period of 18 months and less. (contd..)

BENEFITS OF CREDIT RATING (contd..) As per the guidelines of RBI, one of the condition for issuance of commercial paper in India is that the issue must have rating now below the P2 grade from CRISIL or A2 grade from ICRA or PR2 grade from CARE. As per the guidelines of RBI, Non-Banking Financing Companies (NBFC) having net owned funds of more than Rs. 2 Crores must get their fixed deposit programmes rated by 31st March, 1995 and the NBFC’s having net owned funds of more than Rs. 50 Lakhs (but less than 2 Crore) must get their fixed deposit programme rated by 31st March 1996. The minimum rating required by the NBFC’s to be eligible to raise fixed deposit are FA(-) from CRISIL or MA(-) from ICRA or BBB from CARE . Similar regulation have been introduced by National Housing Bank (NHB) for housing finance companies also. (contd..)

BENEFITS OF CREDIT RATING (contd..) Credit Rating has been made compulsory also for the fixed deposit schemes of NBFC’s registered under the Companies Act.

SOME IMPORTANT ISSUES IN CREDIT RATING Investment and Speculative Grades Surveillance Credit watch Sovereign Rating Ceiling Bank line coverage for Commercial Papers Ownership as a rating consideration RATING PROCESS  RATING PARAMETERS  The objective of assigning a credit rating to a debt instrument issued by any entity is to determine the likelihood of timely repayment of interest and principal. (contd..)

SOME IMPORTANT ISSUES IN CREDIT RATING (contd..) The analytical framework of rating deals with evaluation of both the business and financial risks associated with that entity. The business risk includes an evaluation of industry characteristics, performance, outlook and the operating efficiencies of the corporate. Financial risk is an evaluation of the financial management, cash flow adequacy, earnings forecast and accounting policies. Besides qualitative aspects like management capabilities also play a considerable role in determining a rating. The relative importance of each of these factors could vary from case to case. Rating of Sovereigns Rating of Manufacturing Companies Rating of Banks Ratings of Financial Services Companies Rating of Structured Obligations / Asset Securitizations

METHODOLOGY OF CREDIT RATING Procedure – Investigation, analysis, study and interpretation of various factors. The world of investment is exposed to the continuous onslaught of Political, Economic, Social, Technical, Environmental and Regulations, which does not permit anyone to understand sufficiently and predict anything with absolute certainty. Hence a logical approach to systematic evaluation is necessary and within the framework of certain common features the agencies employ different methodologies. Broadly, the following types of analysis can be found: Economic Analysis Industry Analysis (contd..)

METHODOLOGY OF CREDIT RATING (contd..) Company or Business Analysis Financial Analysis Management Liquidity Earning Power Rating sovereign Countries Country Risk – Probability of incurring a loss on a cross-country claim due to event which are to a certain extent under the control of the Government. Usually country risk is thought of a function of a wide range of economic and political factors. (contd..)

METHODOLOGY OF CREDIT RATING (contd..) Political Risk – Nature of the political system, popular base, stability and responsiveness, the relationship between the executive, judiciary and legislature, the rule of law in society, and the strength of social coalitions. Economic Risk – Evaluated in terms of capital to support existing and anticipated level of external debt, given its liquidity position and the balance of trade and payments flexibility. Credit Rating seeks to establish a link between Risk and Return. Security Analysis requires a wide mix of skills. You need to be an economist with good grasp of both macroeconomics and microeconomics, the former to help you form forecasts of the general direction of the market and the latter to help you assess the relative position of particular industries or firms. You need (contd..)

METHODOLOGY OF CREDIT RATING (contd..) a good sense of demographic and social trends to help identify industries with bright prospects. You need to be a quick study of the ins and outs of particular industries in order to choose the firms that will succeed within each industry. Your need a good accounting background to analyze the financial statements that firms provides. Your also need to have mastered corporate finance, since security analysis at its core is the ability to value firms. In short, a good security analysis will be a generalist, with grasp of widest range of financial issues. This is where there is the biggest premium on “putting it all together”.