Credit Rating

Credit rating is an assessment of the capacity of an issuer of debt security, by an independent agency, to pay interest and repay the principal as per the terms of issue of debt. A rating agency collects the qualitative as well as quantitative data from a company which has to be rated and assesses the relative strength and capacity of company to honour its obligations contained in the debt instrument through out the duration of the instrument. The rating given is based on an objective judgment of a team of experts from the rating agency.

 The ratings are expressed in code number which can be easily comprehended even by the lay investors. The ratings are the quickest way of understanding a companys financial standing without going into the complicated financial reports. Credit rating is only a guidance to the investors and not a recommendation to a particular debt instrument.

The important element for investment decisionmaking in debt security are: Yield to maturity Risk tolerance to investor Credit risk of the security

 A debt rating is not a one- time evaluation of credit risk, which can be regarded as valid for the entire life of the security. It is an on going appraisal. Changes in dynamic world of business may imply a change in the risk characteristics of the security. Hence, debt rating agencies monitor the business and financial conditions of the issuer to determine whether modification in rating is warranted.

Functions of Credit Ratings

Superior Information- Rating by an independent and professional firm offers a superior and more reliable source of information on credit risk for three inter- related risks: It provides unbiased opinion Due to professional resources, a rating firm has greater ability to assess risks. It has access to lot of information which may not be publicly available.

 Low- cost Information- A rating firm gathers, analyses, interprets and summarizes complex information in a simple and readily understood format for wide public consumption represents a cost- effective arrangement.

 Basis for a proper Risk- Return Trade- off- If debt securities are rated professionally and if such ratings enjoy widespread investor acceptance and confidence, a more rational riskreturn trade- off would be established in the capital market.

 Healthy discipline on Corporate BorrowersPublic exposure has healthy influence over the management of issuer because of its desire to have a clear image.

 Formulation of Public Policy Guidelines on Institutional Investment- The public policy on the kinds of securities that are eligible for inclusion in different kinds of institutional portfolios can be developed with great confidence if securities are rated professionally by independent agencies.

Classification of Credit Rating

Debenture and bond rating Equity rating Fixed deposit and certificate of deposit rating Commercial paper rating LPG/ Kerosene dealers/ Firms rating Chit funds rating Real estate developers rating Banks rating Rating of structured obligations Sovereign rating Customer rating

Advantages of Credit Rating

Advantages to Investors
Assessment of credibility Risk indicator Protects against bankruptcy Easy to understand Enables quick decisions Rating surveillance Other services

 Assessment of credibility- Rating assesses the strength and weakness of the company/ debt instrument on the basis of certain predetermined factors. The assessment is carried out judiciously and impartially. Hence, it is beneficial to the investor to understand the credibility of the issuing company.

 Risk indicator- Investors risk perception largely depend on the reputation of the names of the promoters or the collaborations but evaluation based on name recognition cannot be an effective substitute for systematic risk evaluation. A reputed name cannot assure success or be free from default risk. However, a credit rating agency rates the instrument after analyzing the various aspects of the company. All the investors may not possess the required knowledge and information for credit evaluation. The investors can identify the risk associated with them with the symbols assigned to the instruments by the credit rating agency.

 Protects against bankruptcy- The financial strength of the issuing company is assessed through credit rating. High rating assigned to the debt security of a company indicated a safe investment.

 Easy to understand- The rating is given in the forms of symbols. Once the symbols are clearly explained, it is easy to understand and use them. No analytical knowledge is required to understand the rating.

 Enables quick decisions- An investor can take quick decision based upon the rating. There is no need for the investor to understand and use them. No analytical knowledge is required to understand the rating.

 Independent decisions- The investor can build his own portfolio without the help of the portfolio managers, by carefully watching upgrades and downgrades of the credit rating. Investor can make changes in portfolio mix.

 Portfolio diversification- Rating is not only helpful to the individual/ small investors but also to an organized institutional investor. Large investors may use credit rating for portfolio diversification by selecting appropriate instruments from a broad spectrum of investment options.

 Rating surveillance- Rating is not a one- time business. It is a continuously process. Rating agencies continually watch the financial strength and other related factors of the company. If they find that the situation is not up to the mark, they downgrade the instruments and give a warning signal to the investor and the company. The investor has to reorganize his portfolio and the company had to look for alternate ways for strengthening its credibility.

 Other services- The rating agencies conduct research studies and provide industry reports, seminars and open access to analysts of the agencies for discussion.

Advantages to the Issuers

Lowers the cost of borrowing Widens investor base Fosters a better image Induces self discipline Lowers the cost of issue Motivates growth

 Lowers the cost of borrowing- The higher rating for safety provided by the rating agencies builds the investors confidence in the payment of principal and interest. The issuing company can capitalize on this by lowering the rate of interest. The investors who are interested in the safety of the instrument do not mind the marginal decline in the rate of interest. The issuing company could borrow at a low rate of interest as well.

 Widens investor base- The issuers of rated securities are likely to have access to a much wider investor base as compared to unrated securities. The opinions of the rating agency build up investors confidence which could enable the issuers to raise funds in various media.

 Fosters a better image- The financial and managerial performance of an issuer is analyzed and ratings are assigned to their instruments. Rating creates a better image for an issuer. An issuer himself improves his image when he has to get the rating. Hence, it builds a better image for the rated instrument.

 Induces self discipline- Rating requires the disclosure of accounting system, financial reporting and management pattern. This disclosure imposes self discipline on the functioning of the company. An issuer tries to maintain the standard of rating attained by them or to improve the rating which would help them to raise more funds.

 Lowers the cost of issue- A higher rating makes it more accessible to the investor. The rating itself speaks volumes. There is no need to have wide publicity or adopt other ways of publicity like organizing an investors meet or brokers meet. This reduces the cost of the public issue. Further, rating could be used as a benchmark for issue pricing.

 Motivates growth- Rating instills a feeling of confidence and encourages the entrepreneurs to undertake new projects and expand the existing projects. With a higher credit rating, a company can mobilize the needed funds from the public and financial institutions.

Advantages to the Intermediaries

It enables proper planning, pricing, underwriting and placement of the issues. Brokers and dealers could use ratings to monitor their risk exposures. This saves their time, cost, energy and manpower in analyzing the investment risk. Rating is also used in securitization of assets and helps the special purpose vehicle to repackage the assets.

Rating Process
Primary Stage Stage Primary Fact Findings & Analysis Rating Stage Final Stage

1. Rating request 2. Assigning rating team

1. Collection of information 2. Meetings & Plant visits 3. Preparation reports of

1. Preview Meeting
2. Rating Committee Meeting & Rating

1.Communication & acceptance

2. Surveillance

IPO Grading
IPO grading is the grade assigned by a Credit Rating Agency registered with SEBI, to the initial public offering (IPO) of equity shares or any other security which may be converted into or exchanged with equity shares at a later date. The grade represents a relative assessment of the fundamentals of that issue in relation to the other listed equity securities in India.

IPO grading is generally assigned on a five-point point scale with a higher score indicating stronger fundamentals and vice versa as below:

IPO grade 1: Poor fundamentals IPO grade 2: Below-average fundamentals IPO grade 3: Average fundamentals IPO grade 4: Above-average fundamentals IPO grade 5: Strong fundamentals

 IPO grading has been introduced as an endeavor to make additional information available for the investors in order to facilitate their assessment of equity issues offered through an IPO.

IPO grading can be done either before filing the draft offer documents with SEBI or thereafter. However, the Prospectus/Red Herring Prospectus, as the case may be, must contain the grade/s given to the IPO by all CRAs approached by the company for grading such IPO.

 The company desirous of making the IPO is required to bear the expenses incurred for grading such IPO. IPO grading is not optional. A company which has filed the draft offer document for its IPO with SEBI, on or after 1st May, 2007, is required to obtain a grade for the IPO from at least one CRA.

 IPO grade/s cannot be rejected. Irrespective of whether the issuer finds the grade given by the rating agency acceptable or not, the grade has to be disclosed as required under the DIP Guidelines. However the issuer has the option of opting for another grading by a different agency. In such an event all grades obtained for the IPO will have to be disclosed in the offer documents, advertisements etc.

 IPO grading is intended to run parallel to the filing of offer document with SEBI and the consequent issuance of observations. Since issuance of observation by SEBI and the grading process, function independently, IPO grading is not expected to delay the issue process.

 The IPO grading process is expected to take into account the prospects of the industry in which the company operates, the competitive strengths of the company that would allow it to address the risks inherent in the business(es) and capitalise on the opportunities available, as well as the companys financial position.

The areas listed below are taken into consideration for arriving at an IPO grade: Business Prospects & Competitive Position Industry Prospects Company Prospects Financial Position Management Quality Corporate Governance Practices Compliance and Litigation History New Projects- Risk & Prospects

Credit Rating Information Services (CRISIL)

CRISIL, India's first credit rating agency was floated in year 1988, promoted by the erstwhile ICICI Ltd, along with UTI and other financial institutions. A CRISIL rating reflects CRISIL's current opinion on the relative likelihood of timely payment of interest and principal on the rated obligation. It is an unbiased, objective, and independent opinion as to the issuer's capacity to meet its financial obligations.

Objectives of CRISIL
To assist both individual and institutional investors in making investment decisions in fixed income securities. To enable corporate to raise large amounts at fair cost from a wide spectrum of investors. To enable intermediaries in placing their debt instruments with investors by providing them with an effective marketing tool.

The debt obligations rated by CRISIL include: Non-convertible debentures/bonds/preference shares Commercial papers/certificates of deposits/short-term debt Fixed deposits Loans Structured debt

ICRA
ICRA Limited (formerly Investment Information and Credit Rating Agency of India Limited) was set up in 1991 by leading financial/investment institutions, commercial banks and financial services companies as an independent and professional Investment Information and Credit Rating Agency. ICRA and its subsidiaries together form the ICRA Group of Companies (Group ICRA). ICRA is a Public Limited Company, with its shares listed on the Bombay Stock Exchange and the National Stock Exchange.

 The international Credit Rating Agency Moodys Investors Service is ICRAs largest shareholder. The participation of Moodys is supported by a Technical Services Agreement, which entails Moodys providing certain high-value technical services to ICRA. ICRA has launched a quarterly publicationMoney and Finance, it contains various articles that analyze contemporary developments in the Indian money and capital markets.

Objectives
To provide information and guidance to institutional and individual investors/creditors. To enhance the ability of borrowers/issuers to access the money market and the capital market for tapping a larger volume of resources from a wider range of the investing public. To assist the regulators in promoting transparency in the financial markets. To provide intermediaries with a tool to improve efficiency in the funds raising process.

Credit Analysis and Research Limited (CARE)

CARE Ratings commenced operations in 1993. It has been set up by the IDBI in collaboration with some banks and financial institutions. CARE assists the Disinvestment Commission in equity valuation of a number of state owned companies and for suggesting disinvestment strategies for these companies. CARE rating undertakes corporate governance ratings, mutual fund credit quality ratings, IPO grading, claims paying ability rating of insurance companies, grading of construction entities and issuer grading.

Moodys
Moody's Corporation (NYSE: MCO) is the parent company of Moody's Investors Service, which provides credit ratings and research covering debt instruments and securities, and Moody's Analytics, which offers leading-edge software, advisory services and research for credit and economic analysis and financial risk management.

 Moody's is an essential component of the global capital markets, providing credit ratings, research, tools and analysis that contribute to transparent and integrated financial markets. The system of rating securities was originated by John Moody in 1909. The purpose of Moody's ratings is to provide investors with a simple system of gradation by which future relative creditworthiness of securities may be gauged.

 Moodys rating symbols are : Aaa Aa A Baa Ba B Caa Ca C

Standard & Poor's (S&P)

Standard & Poor's (S&P) is an American financial services company. It is a division of The McGraw- Hill Companies that publishes financial research and analysis on stocks and bonds. It is well known for its stock market indices, the U.S.based S&P 500, the Australian S&P/ASX 200, the Canadian S&P/ TSX, the Italian S&P/ MIB and India's S&P CNX Nifty. S&P issues both short-term and long-term credit ratings.

Limitations of Rating
Rating does not recommended buying or sellingA high credit rating should not be considered as a recommendation for buying or selling. It is not necessary that if the debt issue of a company has a Triple A rating, the companys debt is worth investing in. The companys earning and growth prospect are more important. However, credit raters are more interested in the companys solvency and its ability to repay its debt, especially during recession.

 It is issue specific- Rating is given for a particular instrument or issue and not for the company. It is possible for two issues of the same company to have different ratings depending on the characteristics of the instrument. An instrument backed by collateral security will have a higher rating than the one that is unsecured.

 Possibility of getting different ratings- Credit rating are opinions of the credit rating agencies on debt issues of companies. It is quite possible to get different ratings for the same company from two different agencies and it happens often.

 Review Tag- Rating agencies review ratings of a new issue before they hit the market. This means that there might have been a change in the credit quality of the company in the interim period, which might not have been considered by the rating agencies.

 The absence of widespread branch network of the rating agency may limit its skills in rating. Inexperienced, unskilled or overloaded staff may not do justice to their job and the resulting ratings may not be perfect. The rating agencies receive a sizeable fee from the companies for awarding ratings, a tendency to inflate the ratings may develop.