CREDIT RATING

-Kanika Khurana

What is Credit Rating?

Symbolic indicator of the current opinion of the rating agency regarding the relative ability and willingness of the issuer of a financial (debt) instrument to meet the (debt) service obligations as and when they arise. Fee-based, primarily issuer-solicited, financial advisory service

Symbolic Indicator
A simple system of gradation which is easy to understand by investors Long term debt ratings Investment Grades: AAA (Highest security), AA (High Safety), A (Adequate Safety), BBB (Moderate Safety) Sub Investment/ Speculative Grades: BB (Inadequate safety), B (High Risk), C (Substantial Risk), D (Default) + or - signs may be assigned to reflect comparative standing within the category Short term debt ratings P-1 (Highest safety), P-2 (High safety), P-3 (Adequate Safety), P-4 (Inadequate safety), P-5 (Default) + sign may be assigned to reflect comparative standing within the category Various other symbols for rating of structured obligations, mutual funds, Indian states, healthcare institutions, real estate developers etc.

Current opinion
Current- pertains to a specific period of time Implication- needs to be reviewed

Opinion- does not amount to recommendation to buy, hold, sell an instrument; Does not take into account market prices, investors risk preferences etc.

Rating agency
Independent professional organizationopinions may differ because analysis is independent Implication- different ratings for same instrument

Relative ability & Willingness of issuer

Detailed study of all relevant factors- qualitative and quantitative is essential

Rating Methodology for Manufacturing Companies Industry Risk- Growth prospects, market position and image of issuer, other industry characteristics (demand situation, bargaining power, sensitivity to economic cycles etc.) Business Risk- Level of technology, Inventory and receivables management, expense levels and profitability, performance in relation to industry benchmarks, trend of margins, legal position (debt covenants, litigations etc), parent support, size of company Financial Risk- existing financial position, profitability, financial flexibility, liquidity/ cash flow adequacy, leverage, past debt service record, accounting quality, earnings prospects Management Strength- Track record, competence, capabilities under stress, industrial relations, personnel policies, succession plans

Relative ability & Willingness of issuer

Rating Methodology for Financial Companies

Regulatory Environment- Structure and regulatory framework of the financial system, trends in regulation/ deregulation and their impact on the company Fundamental Analysis Capital Adequacy: Net worth vis--vis volume and risk profile of assets Resources: Funding profile, cost and tenor of funds Asset Quality: Credit risk management systems, credit monitoring, sector risk and exposure, management of problem credits Liquidity Management: capital structure, liquid assets, asset-liability matching Profitability and financial position: historic profits, accretion to reserves, spread on funds deployment Interest and tax rate sensitivity

Financial (debt) instrument

Not a general purpose evaluation of the issuer; pertains to a specific instrument/ facility Takes into account specific risks/features of the instrument/facility in question

(Debt) service obligations

Timely payment of interest as well as principal Past debt servicing record- any delays/ defaults

Fee based, Primarily Issuer Solicited

Mostly done on the request of the issuer/borrower of instrument/facility Issuer/ Borrower pays a fees to the CRA, and has an option of not accepting the rating

Financial Advisory Service

Useful for investors, corporates (borrowers/issuers), banks and financial institutions Investor is informed about underlying credit quality of instrument and effect of changes in economic/business conditions or internal factors on the willingness/ability of issuer to repay

Credit Rating in India

1st agency- CRISIL (Credit Rating Information Services of India Ltd.) started in 1988 Since 1991- mandatory credit rating of various instruments by RBI/SEBI, removal of interest rate restrictions- CR assumed a wider role ICRA in 1990, CARE in 1993, Phelps Credit Rating India (now FITCH India) in 1995, Small and Medium Enterprises Rating Agency (SMERA) in 2005, Brickwork Ratings in 2007

Credit Rating Agencies

CRISIL ICRA CARE FITCH SMERA Brickwork

CRISIL
Promoted in 1987 by ICICI Ltd and UTI Commenced operations in Jan 1988 Pioneered credit rating in India Largest CRA; has diversified into other advisory services IPO in 1993 Strategic alliance with Standard and Poors (S&P) Group in 1996 Rates mandated debt obligations of Indian companies, chit funds, real estate developers, NBFCs, Indian states, Business schools, SMEs; Grading of healthcare institutions, IPOs etc. Symbols-AAA, AA etc.; P-1, P-2, P-3 etc.

ICRA
Promoted by IFCI and other shareolders (UTI, LIC, GIC, HDFC Ltd etc) in 1991 Entered into MOU with Moodys Investor Services Rates mandated debt obligations of Indian companies, structured finance, corporate governance, SMEs, Mutual Funds; Grading of IPOs, MFIs, Equity grading etc. Symbols- LAAA, LAA etc; A1, A2, A3 etc.

CARE
Promoted by IDBI jointly with other financial institutions and banks Commenced operations in 1993 Has diversified into other financial and advisory services in a very limited way Rates mandated debt obligations of Indian companies, corporate governance, securitization, insurance companies, SMEs; Grading of IPOs, MFIs etc. Symbols- CARE AAA, CARE AA etc; PR1, PR2 etc.

FITCH
Was a JV between International rating agencyDuff and Phelps, and JM Financials, incorporated in 1995 Now a subsidiary of the global rating agencyFITCH Rates mandated debt obligations of Indian companies, structured finance, Mutual Funds, SMEs; Grading of IPOs etc. Symbols- AAA (ind), AA (ind) etc; F1, F2 etc.

Rating Process- New Issues

Rating Agreement and Assignment of Analytical team Information from issuer and analysis
Annual reports for past 5 years (P/L, Bal Sh, Cash Flow): Standalone and consolidated Financial projections for the next 3-5 years (P/L, Bal Sh, Cash Flow) Copies of loan agreements/ Board resolution for issue of debt/ offer document/ indenture agreement/ sanction letters from banks etc. Details of companys principal officers and board members Analysis of financial statements through accounting ratios, sensitivity analysis, trend analysis, inter-firm comparison, assessment of repayment capacity etc.

Rating Process- New Issues

Meeting with Management- Discussion on:
management philosophy and plans covering past and projected financial and operating data growth plans as reflected in projections covering expenditure on fixed and working capital, financing needs and alternatives, marketing strategies, sales growth and market demand risks and opportunities that affect credit quality: competitive position, strategies, business outlook, historical performance etc.

Rating Process- New Issues

Analysis and preparation of rating report
Financial analysis and risk Business and operations analysis Management strength Industry outlook

Rating Committee
Rating report presented Rating decide after assessment of all factors and key issues Issuer does not participate in this step

Rating Process- New Issues

Communication to issuer
Rating decision communicated along with rationale/ critical analytical factors May appeal for reconsideration on the basis of new information which addresses concerns / May accept rating If appealed, revised report is put up to committee which may or may not change rating Issuer may or may not accept final rating

Dissemination to Public
If accepted, CRAs disseminate rating along with rationale for rating

Rating Process- Review of rating

Annual Surveillance/ Periodical reviews carried out for all existing ratings New data sought on political/ financial/ economic trends, internal data of company (results announcement, achievement of projections, operating data, new plans/projects, mergers etc.) Analysis of preliminary data may suggest need for comprehensive study comprising management meeting, further information and analysis Rating report may be prepared and presented to rating committee and rating action (positive/ negative) may be taken

Rating Process- Review of rating

Rating Action- Upgrade/downgrade within/outside rating band Rating Watch/ Credit watch- when imminent events may lead to a rating change eg. Mergers, pending litigations etc. Credit watch duration is normally 90 days. 4 situations Positive Negative Stable Developing

What all is rated by Indian CRAs?

Debt Ratings Structure Finance Ratings Real Estate Developer Ratings Bond Fund Ratings Bank Loan Ratings Healthcare Institutions Grading Claims Paying Ability Rating Mutual Fund Scheme Grading SME Rating Equity Grading Chit Funds Rating IPO Grading Rating of Indian states LPG/ Kerosene Dealers Rating Mutual Fund Grading Corporate Governance Rating Municipal Corporations Rating

Debt Obligations, Bank Loans

Debentures, preference shares, certificates of deposits, commercial papers, fixed deposits, term loans, working capital loans etc.

Structured Finance
Estimation of expected loss (probability of default X severity of loss) to the investor on the rated instrument, under various possible scenarios Factors: arrangements for payment of instrument like guarantors, asset backing etc. 4 major categories: Asset backed Securitisation (ABS), Mortgage backed Securitisation (MBS), Collateralised Debt Obligation (CDO), Future Flow Transaction (FFT)

Real Estate Developers

Ability of developer to build agreed quality levels within reasonable time and transfer title to customers (specific to a project) Both project risk (legal title of property, quality of construction, timeliness of delivery) and developer risk (track record, existing financial position, financial flexibility, management evaluation) factors are assessed Help developers mobilize funds for projects and market them; help prospective investors to narrow down on investment options

Bond Fund
Opinion on credit quality of bond funds underlying portfolio holdings (mainly money market instruments) Factors considered: Credit associated with securities in fund portfolio, Systems and procedures followed by funds, Management quality and expertise

Collective Investment Schemes

For plantations and other companies Degree of certainty of the scheme to deliver assured returns in terms of quantity of produce and/or cash (Does not offer comments on quality of produce)

Healthcare Institutions
Opinion on relative quality of healthcare delivered by the institution to its patients (Grade is applicable for single facility) Not an opinion on outcome of any treatment/ surgery, suitability of organization for any ailment, recommendation to provide funds to that institution etc. Based on medical specialties, quality of support services, regulatory compliance, financial performance, management evaluation, hospital mission and policy, patient rights, nursing care Benefits- Hospitals: improved credibility which enhances potential business revenues; Patients: ability to choose healthcare institutions on basis of unbiased assessment; Insurance companies-linking level of premium with grades assigned; Third-party administrators: objective criteria in selection of hospitals

Claims Paying Ability

Rating for Insurance Companies giving opinion on ability of insurer to honour policyholder claims and obligations on time Based on asset-liability management method, competitive position, management, investment strategies etc. With multiple private players in insurance, rating will help investors in choice of insurance companies and products

Corporate Governance
Opinion regarding extent to which organization accepts and agrees to codes and guidelines of corporate governance practices that serve interests of stakeholders Aspects examined- ownership structure, stakeholder relations, financial transparency, information disclosure, Board structure, management processes

SME Rating
Opinion on relative degree of capability to repay interest and principal Based on factors like marketing strategies, competitive position, technological development, operational efficiency, management effectiveness, cash flow trends, liquidity, financial flexibility, pas debt servicing record, government policies relating to industry

Equity Grading
Opinion on relative quality of equity shares on the basis of assessment of underlying fundamentals of the company Done by ICRA under EPRA (Earnings Prospects and Risk Analysis) Scheme at the instance of issuers

Rating of Indian States

Ratings have been done mostly on request of foreign infrastructure investors (esp. power sector) Assessment of credit quality of the state and SEBs Based on economic risk (current finances, future economic policies, availability of infrastructure, deficit management strategy, central support, tax policy, performance of its PSUs) and political risk (relationship between state and centre, attitude of political parties towards industry, labour, reforms, current leadership and administration)

Chit Funds
Ability to make timely payment of prize money to the subscribers, relative degree of risk associated with subscription to chit series floated by chit funds Rating enhances marketability of chits, widens access to subscription and provides objective valuation of its strengths and weaknesses

LPG/ Kerosene Dealers

To help consumers identify genuine companies before applying for connection Was made mandatory in 1995 and has to be disclosed in every advertisement Parameters for assessment include market standing, bottling facilities, storage and distribution arrangements, marketing skills, financial stability

Mutual Fund Grading

Independent opinion on performance and risks associated with investing in individual mutual fund schemes For Investors: opinion on performance, credit quality, funds management, interest rate sensitivity, meeting of investment objectives For Intermediaries: offer products matching risk appetite of investors, provide informed advice, differentiate various schemes For AMC: marketing tool, provide benchmark of performance

Municipal Corporations
Evaluation of inherent financial strength of corporation Factors considered- Administrative and legal structure, Economic factors and service provision, Municipal finances, Debt profile and future borrowing needs, quality of administration and management

IPO Grading
Class Presentation