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 decisionmaking. 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 disintermediation

increased securitization of borrowing and lending consequent to disintermediation

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

Fitch India Pvt Ltd

Onida Individual Credit Rating Agency of India Ltd (ONICRA)
(contd..)
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
o
(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

Company or Business Analysis

Financial Analysis
(contd..)
 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.
“putting it all together”.
This is where there is the biggest premium on