Credit Rating
Credit
Rating
Credit rating system organised in
the US
in 70’s. The high levels of default which occurred after the Great Depression,
in the US Capital market gave the impetus for the growth of credit rating. The
default of $82 million of commercial paper by Penn Central in the year 1970 and
the consequent panic of investors in commercial papers resulted in massive
default and liquidity crisis. This prompted the capital issuers to get their
commercial paper programs rated by independent credit rating agencies.
Moreover, regulatory agencies in the US made rating mandatory for
institutions such as Govt. Pension Funds and Insurance companies, who could not
buy securities rated below a particular grade. In addition, investors themselves
became aware of the rating mechanism and started using rating extensively as a
tool for risk management. Merchant bankers, underwriters and other
intermediaries involved in the debt instruments. Many other factors have
contributed to the growth and importance of credit rating system which
includes:
(1)
The
increasing role of capital and money market.
(2)
Increased
securitisation of borrowing and lending.
(3)
Globalization
of credit market.
(4)
Continuing
growth of Information Technology.
(5)
Growth
of confidence in the efficiency of the market mechanism.
(6)
Withdrawal
of Govt. safety nets and trend towards privatization.
The first credit rating agency ‘Mercantile
Credit Agency’ was set up in New York by Louis Tappan in 1841 in order to rate
the ability of merchants to pay financial obligations. The growth of Credit
Rating Agencies is given below:
(i)
1841 -
Mercantile Credit Agency
(ii)
1900 -
Moody’s Investors Service
(iii) 1916
- Poor Publishing Company
(iv) 1922
- Standard Statistics Company
(v)
1924 - Fitch Publishing Company
(vi) 1933
- Dun & Bradstreet
(vii)
1941 -
Standard & Poor
(viii)
1966 -
McGraw Hill
(ix) 1972
- Canadian Bond
Rating Service
(x)
1974 -
Thomson Bank Watch(Tronoto ,
Canada )
(xi) 1975
- Japanese Bond Rating Institute(JCR)
(xii)
1975
- McCarthy Crisanti
and Maffei
(xiii)
1977 -
Dominican Bond
Rating Service
(xiv)
1978 - IBCA
Ltd., London
(xv)
1980 - Duff
& Phelps Credit Rating Company(DCR)
(xvi)
1987
- CRISIL (Credit Rating Information Services of India Ltd.)
(xvii)
1991
- ICRA (Investment Information and Credit Rating Agency of India Ltd.)
(xviii)
1994
- CARE (Credit Analysis and Research Ltd.)
(xix)
1996
- Duff & Phelps Credit Rating India Pvt. Ltd.
According to Moody, “a rating is an
opinion on the future ability and legal obligation of the issuer to make timely
payments of principal and interest on a specific fixed income security;
measures the probability of the issuer and includes the assessment of the
expected monetary loss, should be a default occur”
Features of Credit
Rating
Ø
Specificity:
- Rating is specific to a debt instrument assessing the overall credit risk associated
with that particular instrument.
Ø
Relativity:
- Rating is based on the relative capability and willingness of the issuer of
the instrument to service debt obligations (principal & interest)in
accordance with the terms of the contract.
Ø
Guidance:
- Rating furnishes guidance to investors/creditors in determining credit risk
with debt instrument/credit obligations.
Ø
Rating
doesn’t provide any sort of recommendation to buy, hold or sell an instrument
as it doesn’t take into consideration which influences investment decision.
Ø
Doesn’t
provide any guarantee for the completeness or accuracy of the information on
which rating is based.
Ø
Rating
is based on certain broad parameters supplied by the issuer and also collected
from various other sources including personal interactions with various
entities.
Credit Rating
Process
Contract between Rater &
Client
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Discussion
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Bench Marking
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Advantages
of Credit Rating
To the Investors:
- Adequate
information regarding risk profile debt instrument.
- Check
the quality of the instrument through systematic risk.
- Provide
professional competency by ranking of different debt instrument.
- Symbolic
credit ratings are easy to understand and establish a link between risk
and return.
- It
will be helpful for efficient portfolio management
To the Issuer:
- Credit
rating acts as an index of faith placed by the market in the issuers.
- Provides
wider investor base as compared to other unrated securities.
- Bench
mark: especially for higher rated instruments to access the market even in
the adverse market condition.
To the
Intermediaries:
- Serves
as an efficient tool for merchant bankers and other capital market
intermediaries in the process of planning, pricing, underwriting and
placement issues.
- Rating
provides input for monitoring the risk exposure of brokers and dealers in
the stock exchange.
- Has
facilitated regulatory authorities around the world to issue mandatory
rating requirements.
Rating
Grades
S & P
AAA - Highest
Quality
AA+ - High
Quality
AA - High
Quality with High Risk Obligation
A+ - Strong
Payment Capacity
BBB+
&
- Adequate Payment Capacity
BBB
ICRA
Long Term Debt Medium
Term Short Term
Highest
Safety LAAA MAAA A1+
High
Safety LAA+ MAA+ A2+
Adequate
Safety LA+ MA+ A3+
Moderate
Safety LBBB+ MB+ -
Inadequate
Safety LBB+ - -
Risk
Prone LB+ MC+ A4+
Substantial
Risk LC+ - -
Default
Extremely Speculative LD MD A5
CRISIL
Debenture
Rating Fixed Deposit Short Term
Highest
Safety AAA FAAA P-1
High
Safety AA FAA P-2
Adequate
Safety A FA P-3
Moderate
Safety BBB - -
Inadequate
Safety BB FB -
High
Risk B FC P-4
Substantial
Risk C - -
Default
Extremely Speculative D FD P-5
Factors Determine
the Rating Profile of a Security
1. Business Factors
a) Nature
of the Industry
Stable
business with normal profit with low industrial risk, will be preferred than
higher profit business with high industrial risk.
b) Market
Position
Product
positioning, brand equity, proximity to the markets, distribution network,
supply chain and logistic management and customer relationship will be taken in
to consideration to know the market position of the company.
c)Efficiency
of Operation
Here,
production efficiency and operational efficiency will be measured with input
output ratio.
d) Project
risks
Here,
time and cost over runs, financial tie up, operational risk, market risk etc
will be taken into consideration.
e) Protective
Factors
Here,
the company will look into project cost comparison, track record of technology,
supplier etc.
f) Quality
of Management
Quality
will be measured on the basis of labor relations, returns, management plans and
priorities and implementation, TQM, ISO standards etc.
2. Financial Factors
a) Financial Policies
Here,
the company will look into return for shareholders, asset-liability matching,
currency risk exposure, level of leveraging, investment management, risk
management and portfolio analysis,
b) Flexibility of Financial Structure
Here,
the company will look into market reputation and goodwill, bank relationship,
customer relationship, etc.
c)Past Track Record
Here,
financial analysis and interpretation will be made using ratios, cash flows,
funds flows etc.
d) Quality of Accounting Policies and
Practices will be checked in comparison with GAAP and Accounting Standards and
consistency will be checked.
e) Financial Performance Indicators
Analysis like Profitability, Liquidity, Gearing, Interest Coverage, Cash Flow
etc. will be measured and evaluated.
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