1. 1 Chapter 18 Credit Rating

2. 2  THEORETICAL FRAMEWORK  CREDIT RATING AGENCIES  RATING PROCESS AND METHODOLOGY  RATING SYMBOLS/GRADES

3. 3 THEORETICAL FRAMEWORK  Credit rating is essentially a symbolic indicator of the relative grading of the investment/credit quali­ties of financial instruments and reflects the relative ability of the issuers of such instruments to meet the servicing obligations as and when they arise. It is neither a general purpose evaluation nor an over-all assessment of the credit risk associated with all the obligations of the issuers/corporates. A rating is specific to an

4. 4 instrument. It does not amount to any recommendations to buy, hold or sell an instrument.

5. 5  As a fee-based advisory financial service, credit-rating is of comparatively recent origin in India, the first institution having been set up in 1988.

6. 6 The increasing recognition to credit rating in the country marks a major transition from a corporate culture where names mattered to one where abstract gradings count.

7. 7 CREDIT RATING AGENCIES There are four credit rating agencies in the country which rate corporate entities: CRISIL, ICRA, CARE, FITCH, and SMERA.

8. 8 CRISIL CRISIL is the most important rating agency in the country. Its main business is rating services although it has diversified into information and advisory services. While it undertakes rating of mandated instruments, namely, debentures, deposits, commercial papers, LPG/kerosene dealers, its rating services also extend to preference shares, structured obligations, chit funds, real estate developers/builders, banks and states. The

9. 9 extensive compilation and analysis of data for rating business is also used by CRISIL to provide information services to corporate clients. It has leveraged its information base and expertise in credit rating to provide counselling to government, banks and financial institutions on aspects such as privatisation of PSUs, debt securitisation, credit evaluation and so on.

10. 10 ICRA ICRA focuses on rating of instruments for which credit rating is mandatory, namely, debentures/ bonds, deposits, commercial papers, kerosene/LPG dealers. In addition, it rates banks. It has also ventured into EPRA for grading the primary market at the instance of the issuing companies and assessing the secondary market for the investors. It also provides credit assessment and general assessment services.

11. 11 CARE CARE confines to normal rating business only and has not diversified its operations. The instru­ments credit-rated by CARE are debentures, deposits, commercial papers and structured obliga­tions. It also undertakes general credit analysis of companies for the use of banks, other lenders and business enterprises.

12. 12 SMERA SM ERA focuses exclusively on the rating of small and medium enterprises.

13. 13 Rating Process/Methodology Procedurally, credit rating is done in India at the instance of the issuers of the instruments. Unsolicited rating at the initiative of the rating agencies has still not emerged. The clients have, moreover, the option not to accept the ratings.

14. 14 Rating is a search for fundamentals and the possibilities of change in these in the long- term. All the credit agencies follow broadly the same analytical framework of rating methodology. It comprises of three broad sets of factors: (i) business analysis in terms of analysis of industry risk, market posi­tion, operating efficiency and legal position; (ii) financial analysis on the basis of consideration of accounting quality, earnings protection, adequacy of cash flows and financial flexibility and (iii) management

15. 15 evaluation. For finance companies, in addition, the assessment by the rating agen­ cies lays emphasis on regulatory environment and fundamental analysis which includes liquidity management, asset quality, profitability and financial position and interest and tax sensitivity.

16. 16 The technique of credit rating is rating symbols. They group together similar entities in terms of their relative capacity of timely servicing of obligations as per the terms of the contract. The suffixes plus (+) or minus (—) are added to the symbols to indicate the relative position of the instrument within the group covered by the symbol. Appropriate prefixes and suffixes such as Rating Symbols

17. 17 (FD)/(CD)/Pf/SO/L/F/M/P/A/PR are used to denote specific instruments such as fixed/certificates of deposits, preference shares, long-term, medium term, commercial paper and so on. The rating of LPG/Kerosene dealers is expressed as good, satisfactory, low risk and high risk. The credit assessment symbols are nu­merals ranging between 1-14, while the credit analysis has five ranges between 1-5. Crisil uses five-bold classification as in the case of debentures with the word CHIT as a prefix for chit funds andPA for builders. The grading the primary market by ICRA is classified into four broad

18. 18 categories in descending order of earnings prospects. Each group has three sub-grades correlated with the degree of risk as a result of changes in economic and business conditions, the letters (ER) added as a prefix to each grade. The opinion of Icra is not expressed in terms of symbols but in terms of a report specific to the needs of the investor in the case of assessment of secondary markets. Simi­larly, the ratings of the banks and states are also submitted as reports rather than symbols.

19. 19 CRISIL Rating Symbols The rating symbols of the CRISIL are illustrated with reference (1) debentures, (2) fixed deposits, (3) short-term instruments (commercial papers), (4) credit assessment, (5) structured obligations, (6) bond funds, (7) bank loans (8) collective investment schemes, (9) Indian states, (10) chit funds and (11) real estate developers/builders. Debentures The rating of debentures is mandatory. The CRISIL assigns an alpha based rating scale to rupee denominated debentures. It categorises them into three grades namely, high investment, investment and speculatives. High Investment Grade High investment includes: AAA - (Triple A) Highest Security The debentures rated’ AAA ‘ are judged to offer the highest safety against timely payment of interest and principal. Though the circumstances providing this degree of safety are likely to change, such changes as can be envisaged are most unlikely to affect adversely the fundamentally strong position of such issues. AA - (Double A) High Safety The debentures rated ‘AA’ are judged to offer high safety against timely payment of interest and principal. They differ in safety from’ AAA ‘ issues only marginally. Investment Grades Investment grades are divided into:

20. 20 A- Adequate Safety The debentures rated ‘A’ are judged to offer adequate safety against timely payment of interest and principal; however, changes in circumstances can adversely affect such issues more than those in the higher rated categories. BBB- (Triple B) Moderate Safety The debentures rated ‘BBB’ are judged to offer sufficient safety against timely payment of interest and principal, for the present; however, changing circumstances are more likely to lead to a weakened capacity to pay interest and repay the principal than in the case of debentures in higher rated categories. Speculative Grades Speculative grades comprise: BB- (Double B) Inadequate Safety The debentures rated ‘BB’ are judged to carry inadequate safety of the timely payment of interest and principal. While they are less susceptible to default than other speculative grade debentures in the immediate future, the uncertainties that the issuer faces could lead to inadequate capacity to make interest and principal payments on time. B- High Risk The debentures rated ‘B’ are judged to have greater susceptibility to default. While currently interest and principal payments are met, adverse business or economic conditions would lead to a lack of ability or willingness to pay interest or principal. C- Substantial Risk The debentures rated ‘C’ are judged to have factors present that make them vulnerable to default; timely payment of interest and principal is possible only if favourable circumstances continue.

21. 21 D- Default The debentures rated ‘D’ are in default and in arrears of interest or principal payments or are expected to default on maturity. Such debentures are extremely speculative and returns from these debentures may be realised only on reorganisation or liquidation. Note: (1) The CRISI may apply ‘+’ (plus) or ‘–’ (minus) signs for ratings from AA to C to reflect comparative standing within the category. The contents within parentheses are a guide to the pronunciation of the rating symbols. Preference shares rating symbols are identical to debenture rating symbols except that the letters ‘pf’ are prefixed to the rating symbols for example pf AAA (“pf Triple A”). Fixed Deposits The fixed deposits are divided into six broad groups. The + (plus)/– (minus) signs may be applied for ratings from grade two to grade six to reflect comparative standing within the grade/category. The symbols and their implications are described below. FAAA-(F-Triple A) Highest Safety This rating indicates that the degree of safety regarding timely payment of interest and principal is very strong. FAA-(F-Double A) High Safety This rating indicates that the degree of safety regarding timely payment of interest and principal is strong. However, the relative degree of safety is not as high as for the fixed deposits with ‘FAAA’ rating.

22. 22 FA-Adequate Safety This rating indicates that the degree of safety regarding timely payment of interest and principal is satisfactory. Changes in circumstances can affect such deposits more than those in the higher-rated categories. FB-Inadequate Safety This rating indicates inadequate safety of timely payment of interest and principal. Such deposits are less susceptible to default than fixed deposits rated below this category, but the uncertainties that the issuer faces could lead to inadequate capacity to make timely interest and principal payments. FC-High Risk This rating indicates that the degree of safety regarding timely payment of interest and principal is doubtful. Such deposits have factors at present that make them vulnerable to default; adverse business or economic conditions would lead to lack of ability or willingness to pay interest or principal. FD-Default This rating indicates that the deposits are either in default or expected to be in default upon maturity. Short-Term Instruments Such instruments include commercial papers. Their rating is also mandatory. The CRISIL grades them into five broad groups, as listed below.

23. 23 P-1 (Highest Safety) This rating indicates that the degree of safety, regarding timely payment of the instrument, is very strong. P-2 (High Safety) 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 “P-l”. P-3 (Adequate Safety) 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. P-4 (Inadequate Safety) 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 favourable conditions. P-5 (Default) This rating indicates that the instrument is expected to be in default upon maturity or is in default. The CRISIL may apply “+” (plus) sign for ratings from P-l to P-3 to reflect a comparatively higher standing within the category. Credit Assessment The assessment indicates the CRISIL’s broad opinion as to the relative degree of capability of the entity to repay the interest and principal, as per the terms of the contract. It indicates credit assessment symbols (as distinct from credit rating symbols) by numerals ranging from 1 to 14, detailed below, which roughly correspond to the medium-term instruments rating symbols.

24. 24 1-Very Strong Capacity This indicates that the capacity for timely payment of interest and principal is very strong. 2, 3, 4 Strong Capacity This indicates that the capacity for timely payment of interest and principal is strong. However, the capacity is not as strong as for borrowers with a credit assessment of “1”. 5, 6, 7 Adequate Capacity This indicates that the capacity for timely payment of interest and principal is satisfactory. Changes in circumstances can affect the capacity of the borrower, more than those in the stronger credit assessment categories. 8, 9, 10 Inadequate Capacity This indicates inadequate capacity for timely payment of interest and principal. Such borrowers are less susceptible to default than borrowers with credit assessment below this category, but the uncertainties that the borrower faces could lead to inadequate capacity to make timely interest and principal payment. 11, 12, 13 Poor Capacity This indicates that the capacity for timely payment of interest and principal is doubtful. At present, such borrowers face circumstances that make them vulnerable to default; adverse business or economic conditions would lead to a lack of capacity to pay interest or principal. 14 Default This indicates that the borrower is either in default or is expected to be in default upon the maturity of the debt.

25. 25 Structured Obligations The structured obligations ratings are based on the same scale (AAA through D) as ratings for long-term instruments. However, reflecting the distinction of structured obligations from a debt instrument, the rating symbols are defined differently. Grades are classified into (1) high investment, (2) investment and (3) speculative. High Investment Grades These grades comprise: AAA(SO) Highest Safety This rating indicates the highest degree of certainty regarding timely payment of financial obligations on the instrument. Any adverse changes in circumstances are most unlikely to affect payments on the instruments. AA(SO) High Safety This rating indicates the highest degree of certainty regarding timely payment of financial obligations on the instrument. This differs only marginally in safety from ‘AAA(SO)’ instruments. Investment Grades Investment grades include: A(SO) Adequate Safety This rating indicates adequate degree of certainty regarding timely payment of financial obligations on the instrument. Changes in circumstances can adversely affect such instruments more than those in the higher-rated categories.

26. 26 BBB(SO) Moderate Safety This rating indicates a moderate degree of certainty regarding timely payment of financial obligations on the instrument. However, changing circumstances are more likely to lead to a weakened capacity to meet financial obligations than for instruments in higher-rated categories. Speculative Grades Speculative grades consist of: BB(SO) Inadequate Safety This rating indicates an inadequate degree of certainty regarding timely payment of financial obligations on the instrument. Such instruments are less susceptible to default than instruments rated below this category. B(SO) High Risk This rating indicates high risk and greater susceptibility to default. Any adverse business or economic conditions would lead to a lack of capability or willingness to meet financial obligations on time. C(SO) Substantial Risk This rating indicates that the degree of certainty regarding timely payment of financial obligations is doubtful unless circumstances are favourable. D(SO) Default This rating indicates that the obliger is in default or expected to default. Note: The CRISIL may apply ‘+’ (plus) or ‘–’ (minus) signs for ratings from AA(SO) to C(SO) to reflect comparative standing within the category.

27. 27 Bond Funds The rating symbols and their interpretation are as follows: AAAf The fund’s portfolio holdings provide very strong protection against losses from credit defaults. AAf The fund’s portfolio holdings provide strong protection against losses from credit defaults. Af The fund’s portfolio holdings provide adequate protection against losses from credit defaults. BBBf The fund’s portfolio holdings provide moderate protection against losses from credit defaults. BBf The fund’s portfolio holdings provide inadequate protection against losses from credit defaults. Cf The fund’s portfolio holdings have factors present that make them vulnerable to credit defaults. Bank Loan Ratings (BLRs) The BLRs and their interpretation are given below. BLR-l A strong likelihood of repayment of interest and principal on the bank loan. BLR-2 A good likelihood of repayment of interest and principal on the bank loan. BLR-3 A satisfactory likelihood of repayment of interest and principal on the bank loan.

28. 28 BLR-4 A moderate likelihood of repayment of interest and principal on the bank loan. BLR-5 Sub-standard; vulnerability to loss. BLR-6 Loss; high likelihood of loss. Collective Investment Schemes The CRISIL has developed a framework for the rating of collective investment schemes of plantations and other companies. The rating is an opinion on the degree of certainty of the scheme to deliver the assured returns, in terms of the quantity of produce and/or cash, as mentioned in the offer document. The rating is not a comment on the quality of the produce or the monetary value that all the investors will get from the produce. The methodology broadly assesses the scheme-related risk factors as well as promoter-related risk factors. Under each of these, the CRISIL has identified factors that it believes, would have impact on the degree of certainty of the scheme providing an assured return to the investor. These factors are crystallised into a composite rating expressed in the form of grades. The symbols divide them into five grades, as detailed below: Grade I (High Certainty) This rating indicates high certainty that the collective investment scheme will provide the assured returns in the form of produce and/or cash. Grade II (Adequate Certainty) This rating indicates adequate certainty that the collective investment scheme will provide the assured returns in the form of produce and/or cash.

29. 29 Grade III (Moderate Certainty) This indicates moderate certainty that the collective investment scheme will provide the assured returns in the form of produce and/or cash. Grade IV (Inadequate Certainty) This rating indicates inadequate certainty that the collective investment scheme will provide the assured returns in the form of produce and/or cash. Risk factors for the scheme are high and the scheme is prone to default. Grade V (High Uncertainty) This rating indicates high uncertainty that the collective investment scheme will provide the assured returns in the form of produce and/or cash. Risk factors for the scheme are extremely high expectation of default on obligations.

30. 30 Rating of Chit Funds The CRISIL undertakes rating of chit funds incorporated as public/private limited companies, typically having an operating track record of at least 10 years, with a reported minimum net worth of Rs 5 1akh. Such rating is, however, not mandatory. The purpose of the rating of chit funds is to assess their ability to make timely payment of the prize money to the subscribers. It also reflects the relative degree of risk associated with subscription to the chit series floated by chit funds. Moreover, a rating enhances the marketability of chits, widens the access to subscribers, provides a distinct identity to the chit fund and an objective evaluation of its strengths and weaknesses. The rating process and methodology is the same as in the case of mandated instruments. The rating symbols and their broad interpretations are listed below. Investment Grade: CHIT AAA-Very High Safety This rating indicates that the degree of safety regarding timely payment to the subscribers is very strong. CHIT AA+/CHIT AA/CHIT AA-High Safety This rating indicates that the degree of safety regarding timely payment to the subscribers is strong. CHIT A+/CHIT A/CHIT A-Adequate Safety This rating indicates that the degree of safety regarding timely payment to the subscribers is satisfactory.

31. 31 Speculative Grade: CHIT B+/CHIT B/CHIT B- Inadequate Safety This rating indicates inadequate safety of timely payment to subscribers. While such chit funds are less susceptible to delay/default than chit funds rated below this category, the uncertainties that such chit funds face could lead to inadequate capacity to make timely payments to subscribers. CHIT C+/CHIT C/CHIT C-High Risk This rating indicates that the degree of safety regarding timely payment to the subscriber is doubtful. Such chit funds have factors at present which make them vulnerable to default; adverse business conditions would lead to lack of ability or willingness to pay subscribers. CHIT D Default This indicates that the chit fund is either in default or is expected to be in default. Rating of Real Estate Developers/Builders The CRISIL undertakes rating of real estate projects. The rating pertains to a particular project and not to the company as a whole. Only projects with an approved plan and planning permit from the appropriate local authorities are considered for a rating. Methodology The CRISIL assigns ratings after assessing the factors that could affect the ability of the developer to meet agreed specifications in terms of quality and time, as well as the ability to transfer clear title to customers. The ratings are based on current information provided to the CRISIL. The considered factors are: (i) project risk analysis and (ii) developer risk analysis.

32. 32 Project Risk Analysis The quality of legal title, in respect of the property to be constructed, quality of construction and timeliness of delivery of the proposed/completed unit are assessed. The analysis of quality takes into account the specifications agreed upon by the developer and the buyers. Developer Risk Analysis The track record of the developer, existing financial position, financial flexibility and management evaluation are some of the factors considered in order to assess the standing of the developer. The key documents for scrutiny at the time of rating are: ·Registered sale deeds for all transfers over the past 30 years or from the time a clear proof of title is established; time a clear proof of title is established; ·A report on the title, from a reputed legal firm/lawyer or from the appropriate authority; appropriate authority; ·Copy of the sanctioned plan, together with commencement and completion certificates, as applicable; completion certificates, as applicable; ·Copies/formats of all agreements between the developer and the buyer(s); buyer(s); ·Receipts of all municipal and government rates, duties and taxes in respect of the property paid to date; respect of the property paid to date; ·Exemption order under the Urban Land Ceiling Act, 1976, from a competent authority, if applicable and competent authority, if applicable and ·Clearance certificate under the Income Tax Act.

33. 33 Rating Symbols The rating of builders is not mandatory. The CRISIL, however, rates them as a part of its diversification strategy. It uses the prefix (PA) to the rating symbols to indicate the project development ability of the developer. The rating symbols it uses and their interpretation are indicated below. PA1 Highest Ability Projects rated PA1 indicate the highest ability of the developer to specify and build to the agreed quality levels, and transfer clear titles within stipulated time schedules. PA2 High Ability The developer’s ability to build the project to specified quality levels and time schedules and transfer clear title is high. Project risks are marginally higher in this category as compared to projects in the PA1 category. PA3 Adequate Ability Adequate ability of the developer to build to reasonable quality levels and time schedules and transfer clear title for the present. However, changing circumstances are likely to adversely affect these projects more than those in the higher rated categories. PA4 Inadequate Ability The developer’s ability to build to specified quality levels and adhere to time schedules is inadequate. Uncertainties facing the project could result in inability and/or unwillingness to complete projects. PA5 Inability Projects rated PA5 indicate the inability of the developer to complete projects or transfer clear titles. Note: The CRISIL may apply ‘+’ (plus) sign for ratings PA1 to PA3 to reflect comparative standing within the category.