WHAT IS CREDIT RATING?

CREDIT RATING

What is Credit Rating ?

Credit Rating means an assessment made from credit-risk evaluation, translated into a current opinion as on a specific date on the quality of specific debt security issued or on obligation undertaken by an enterprise in terms of the ability and willingness of the obligator to meet principal and interest payments on the rated debt instrument in a timely manner.

Thus Credit Rating is:
(1) An expression of opinion of a rating agency.
(2) The opinion is in regard to a debt instrument.
(3) The opinion is as on a specific date.
(4) The opinion is dependent on risk evaluation.
(5) The opinion depends on the probability of interest and principal obligations being met timely.

Such opinions are relevant to investors due to the increase in the number of issues and in the presence of newer financial products viz. asset backed securities and credit derivatives.

Credit Rating does not in any way linked with:
(1) Performance Evaluation of the rated entity unless called for.
(2) Investment Recommendation by the rating agency to invest or not in the instrument to be rated.
(3) Legal Compliance by the issuer-entity through audit.
(4) Opinion on the holding company, subsidiaries or associates of the issuer entity.

It should be noted that rating is a continuous process and as new information come, an earlier rating can be revised.

Credit Rating Agencies in India

Around 1990, Credit Rating Agencies started to be set up in India. All the credit rating agencies in India are regulated by SEBI (Credit Rating Agencies) Regulations, 1999 of the Securities and Exchange Board of India Act, 1992. 

There are a total of six credit agencies in India viz, CRISIL, ICRA, CARE, SMREA, Brickwork Rating, and India Rating and Research Pvt. Ltd.

1. Credit Rating Information Services ofIndia Ltd. (CRISIL) –

CRISIL was launched in the country in 1987 the prereforms era, CRISIL has grown in size and strength over the years to become one of the top five globally rated agencies. It has a tie up with Standard and Poor’s (S & P) of USA holding 10% stake in CRISIL. It has also set up CRIS – RISC a subsidiary for providing information and related services over the internet and runs an online news and information service. CRISIL’s record of ratings covers 1800 companies and over 3600 specific instruments.

2. Investment Information and CreditRating Agency of India Ltd. (ICRA) –

It began its operations in 1991. Its major shareholders are leading financial institutions and banks. Moody’s Investor Services through their Indian subsidiary, Moody’s Investment Company India (P) Ltd. is the single largest shareholder. ICRA covers over 2500 instruments.

3. Credit Analysis and Research Ltd. (CARE) –

It was established in 1993. UTI, IDBI and Canara Bank are the major promoters. CARE has over 2500 instruments under its belt and occupies a pivotal position as a rating entity. CARE offers two different categories of bank loan ratings, long-term and short-term debt instruments. The company also offers ratings for Initial Public Offerings (IPOs), real estate, renewable energy service companies (RESCO), financial assessment of shipyards, Energy service companies (ESCO) grades various courses of educational institutions. 

4. Fitch Ratings India (P) Ltd. –

The Fitch Group, an internationally recognized statistical rating agency has established its base in India through Fitch Rating India (P) Ltd. as a 100% subsidiary of the parent organization. Its credit rating apply to a variety of corporates / issues and is not limited to governments, structured financial arrangements and debt instruments.

5. Brickwork Ratings (BWR) –

Brickwork Rating was established in 2007 and is promoted by Canara Bank. It offers ratings for bank loans, SMEs, corporate governance rating, municipal corporation, capital market instrument, and financial institutions. It also grades NGOs, tourism, IPOs, real estate investments, hospitals, IREDA, educational institutions, MFI, and MNRE. Brickwork Ratings is recognised as external credit assessment agency (ECAI) by Reserve Bank of India (RBI) to carry out credit ratings in India.

6. Small and Medium Enterprises Rating Agency of India (SMERA) –

Established in 2005, SMERA is a joint initiative of SIDBI, Dun & Bradstreet India and leading banks in India. SMERA has joined hands with prominent institutions such as IIT Madras, The Bangladesh Rating Agency Limited, CAFRAL, CoinTribe, and SIES. Apart from its shareholder banks, SMERA has also entered into MoUs with over 30 Banks, Financial Institutions and Trade Associations of the country.

All the six agencies are recognized by SEBI.

Credit Rating Process

The default-risk assessment and quality rating assigned to an issue are primarily determined by three factors -
(i) The issuer's ability to pay,
(ii) The strength of the security owner's claim on the issue, and
(iii) The economic significance of the industry and market place of the issuer.

The steps involved are:

(1) Request from issuer and analysis –

A company approaches a rating agency for rating a specific security. A team of analysts interact with the company’s management and gathers necessary information. Areas covered are historical performance, competitive position, business risk profile, business strategies, financial policies and short/long term outlook of performance. Also factors such as industry in which the issuer operates, its competitors and markets are taken into consideration.

(2) Rating Committee –

On the basis of information obtained and assessment made the team of analysts present a report to the Rating Committee. The issuer is not allowed to participate in this process as it is an internal evaluation of the rating agency. The nature of credit evaluation depends on the type of information provided by the issuer.

(3) Communication to management and appeal –

The Rating decision is communicated to the issuer and then supporting the rating is shared with the issuer. If the issuer disagrees, an opportunity of being heard is given to him. Issuers appealing against a rating decision are asked to submit relevant material information. The Rating Committee reviews the decision although such a review may not alter the rating. The issuer may reject a rating and the rating score need not be disclosed to the public.

(4) Pronouncement of the rating –

If the rating decision is accepted by the issuer, the rating agency makes a public announcement of it.

(5) Monitoring of the assigned rating –

The rating agencies monitor the on-going performance of the issuer and the economic environment in which it operates. All ratings are placed under constant watch. In cases where no change in rating is required, the rating agencies carry out an annual review with the issuer for updating of the information provided.

(6) Rating Watch –

Based on the constant scrutiny carried out by the agency it may place a rated instrument on Rating Watch. The rating may change for the better or for the worse. Rating Watch is followed by a full scale review for confirming or changing the original rating. If a corporate which has issued a 5 year 8% debenture merges with another corporate or acquires another corporate, it may lead to the listing of the specified.

(7) Rating Coverage –

Ratings are not limited to specific instruments. They also include public utilities; financial institutions; transport; infrastructure and energy projects; Special Purpose Vehicles; domestic subsidiaries of foreign entities. Structured ratings are given to MNCs based on guarantees or Letters of Comfort and Standby Letters of Credit issued by the banks. The rating agencies have also launched Corporate Governance Ratings with emphasis on quality of disclosure standards and the extent to which regulatory obligations have been complied with.

(8) Rating Scores –

A comparative summary of Rating Score used by four rating agencies in India is given below.

Sample of Rating Scores

Debentures	CRISIL	ICRA	CARE	FITCH
Highest Safety	AAA	LAAA	CARE AAA (L)	IND AAA
High Safety	AA	LAA	CARE AA (L)	IND AA
Adequate Safety	A	LA	CARE A (L)	IND A
Moderate Safety	BBB	LBBB	CARE BBB (L)	IND BBB
Inadequate Safety	BB	LBB	CARE BB (L)	IND BB
High Risk	B	LB	CARE B (L)	IND B
Substantial Risk	C	LC	CARE C (L)	IND C
Default	D	LD	CARE D (L)	IND C
Fixed Deposits
Highest Safety	FAAA	MAAA	CARE AAA	TAAA
High Safety	FAA	MAA	CARE AA	TAA
Adequate Safety	FA	MA	CARE A	TA

Uses of Credit Rating

For users –

(i) Aids in investment decisions.
(ii) Helps in fulfilling regulatory obligations.
(iii) Provides analysts in Mutual Funds to use credit ratings as one of the valuable inputs to their independent evaluation system.

For issuers –
(i) Requirement of meeting regulatory obligations as per SEBI guidelines.
(ii) Recognition given by prospective investors of providing value to the ratings which helps them to raise debt/equity capital.

The rating process gives a viable market driven system which helps individuals to invest in financial instruments which are productive assets.

Limitations of Credit Rating
(1) Rating Changes – Ratings given to instruments can change over a period of time. They have to be kept under rating watch. Downgrading of an instrument may not be timely enough to keep investors educated over such matters.

(2) Industry Specific rather than Company Specific – Downgrades are linked to industry rather than company performance. Agencies give importance to macro aspects and not to micro ones; over-react to existing conditions which come from optimistic / pessimistic views arising out of up / down turns.

(3) Cost Benefit Analysis – Rating being mandatory, it becomes a must for entities rather than carrying out Cost Benefit Analysis. Rating should be left optional and the corporate should be free to decide that in the event of self-rating, nothing has been left out.

(4) Conflict of Interest – The rating agency collects fees from the entity it rates leading to a conflict of interest. Rating market being competitive there is a distant possibility of such conflict entering into the rating system.

(5) Corporate Governance Issues – Special attention is paid to-

(a) Rating agencies getting more of its revenues from a single service or group.
(b) Rating agencies enjoying a dominant market position engaging in aggressive competitive practices by refusing to rate a collateralized/securitized instrument or compelling an issuer to pay for services rendered.
(c) Greater transparency in the rating process viz. in the disclosure of assumptions leading to a specific public rating.

Camel Model in Credit Rating

CAMEL Stands for Capital, Assets, Management, Earnings and Liquidity. The CAMEL model adopted by the Rating Agencies deserves special attention it focuses on the following aspects:

(a) Capital – Composition of Retained Earnings and External Funds raised; Fixed dividend component for preference shares and fluctuating dividend component for equity shares and adequacy of long term funds adjusted to gearing levels; ability of issuer to raise further borrowings.

(b) Assets – Revenue generating capacity of existing/proposed assets, fair values, technological / physical obsolescence, linkage of asset values to turnover, consistency, appropriation of methods of depreciation and adequacy of charge to revenues. Size, ageing and recoverability of monetary assets viz. receivables and its linkage with turnover.

(c) Management – Extent of involvement of management personnel, team-work, authority, timeliness, effectiveness and appropriateness of decision making along with directing management to achieve corporate goals.

(d) Earnings – Absolute levels, trends, stability, adaptability to cyclical fluctuations ability of the entity to service existing and additional debts proposed.

(e) Liquidity – Effectiveness of working capital management, corporate policies for stock and creditors, management and the ability of the corporate to meet their commitment in the short run.

These five aspects form the five core bases for estimating credit worthiness of an issuer which leads to the rating of an instrument. 

Rating agencies determine the pre-dominance of positive/negative aspects under each of these five categories and these are factored in for making the overall rating decision.

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Sources: ICAI Material