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

Sending Expert Team to Client Place

Data Collection

Data Analysis

Discussion

Credit Report Preparation

Submission to Grading Committee

Grade Commission to Client

 

Bench Marking

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.