Credit Rating Ruchita Agarwal

Agenda What are Credit Ratings? Leading Rating Agencies Understanding Rating Scales Users of Credit Ratings Ratings Process Parameters for Credit Rating Revenue basis for Rating agencies Examples of Rating agency reports and analysis of contents

What are Credit Ratings ? An assessment by a specialist unbiased agency on the debt repayment ability of a borrower The agency assesses the ‘Credit risk’ involved and provides a certain rating to issuer of debt or the debt instrument itself. What is Credit Risk?

Credit Risk The risk of loss of principal, or loss of a financial reward stemming from a borrower's failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises whenever a borrower is expecting to use future cash flows to pay a current debt. Credit RiskSolvency RiskLiquidity Risk Complete default on agreed payments Delay in payments due from a borrower What are Credit Ratings ?

Is Credit Rating an assurance or an indicator?? Credit ratings are opinions about credit risk published by a rating agency. They express opinions about the ability and willingness of an issuer, such as a corporation, state or city government, to meet its financial obligations in accordance with the terms of those obligations. Credit ratings are also opinions about the credit quality of an issue, such as a bond or other debt obligation, and the relative likelihood that it may default. Ratings should not be viewed as assurances / guarantees of credit quality or exact measures of the likelihood of default. Rather, ratings denote a relative level of credit risk that reflects a rating agency’s carefully considered and analytically informed opinion as to the creditworthiness of an issuer or the credit quality of a particular debt issue. What are Credit Ratings ?

Hence, credit ratings are… Opinions not assurances Forward looking Continually Evolving and not Static Do not guarantee merit of an investment Should not be considered as a buy-sell recommendation What are Credit Ratings ?

Solicited vs Unsolicited Ratings Publicly registered securities are nearly always rated. In some cases, rating agencies will assign a rating without a request from the issuer. These are called unsolicited (a.k.a agency-initiated) ratings. However, the agency always has to disclose the nature of the rating. Whether the rating is solicited or not, the rating agency will offer to meet with the issuer and give them the opportunity to appeal their ratings. TYPES OF RATINGS?

Investment grade vs. Speculative Grade IG characteristics: ▫Firms with adequate repayment capacity ▫Firms are of highest quality ▫Have strong financial operations SG characteristics: ▫Firms with higher risks associated with their ability to repay obligations ‘Securities rated as IG are sometime downgraded into the SG category which often necessitates a sale of those ‘fallen angels’. TYPES OF RATINGS?

Rating Agencies Global: ▫Standard & Poor's ▫Moody's ▫Fitch Indian ▫Credit Rating and Information Services of India (CRISIL) ▫Investment Information and Credit Rating Agency of India Ltd (ICRA) ▫Credit Analysis and Research Ltd (CARE)

CRISIL (An S&P company) Jointly promoted by ICICI and UTI in 1987 along with few other promoters and was the first credit rating agency in India. Services rendered are: ▫Rating Services – Debentures, Preference Shares, Commercial Paper, Banks, States, Fixed Deposits, PTC’s (Pass through certificate), Structured Finance Instruments etc ▫Information Services – Data and analysis on Indian companies ▫Advisory Services – to the Govt, banks and Financial Institutions Rating Agencies in India

ICRA (A Moody’s Company) Promoted by IFCI in 1991 Services Rendered are: ▫Rating services for debentures/bonds, preference shares, medium term debts including Certificates of Deposits as well as short term instruments ▫Earning Prospects and Risk Analysis ▫Rating of LPG/Kerosene firms/dealers ▫Credit Assessment and General Assessment Rating Agencies in India

CARE Jointly promoted by IDBI along with banks and finance companies in Services rendered are: ▫Credit Rating Services for Debentures, Fixed Deposits, Commercial Paper etc ▫General and confidential Rating useful for bankers and other lenders Rating Agencies in India

Rating Scales Comparison: CRISILICRACARE Long Term: High Investment Grade AAA and AALAAA, LAA+, LAACARE AAA, CARE AA, CARE A Investment GradeA and BBBLA+, LA, LA-, LBBB+, LBBB, LBBB- CARE BBB, CARE BB, CARE B Speculation GradeBB, B, C and DLBB+, LBB, LBB-, LB+, LB, LB-, LC+, LC, LC-, LD CARE C, CARE D Medium Term:FAAA, FAA, FA, FB, FC, FD MAAA, MAA+, MAA, MAA-, MA+, MA, MA-, MB+, MB, MB-, MC+, MC, MC-, MD Same as Long term Short Term:P1, P2, P3, P4, P5A1+, A1, A2+, A2, A3+, A3, A4+, A4, A5 PR-1, PR-2, PR-3, PR-4, PR-5

Example of rating scales

Who are the users of Credit Ratings? Investors (Retail, HNI etc) Intermediaries (Investment Banks etc) Capital Market participants Businesses & Financial Institutions Issuers

Who are the users of Credit Ratings? Investors (Retail, HNI etc) Intermediaries (Investment Banks etc) Capital Market participants Businesses & Financial Institutions Issuers

Investors to help assess credit risk when making investment decisions to compare different issuers and debt issues when managing their portfolios Intermediaries (eg. Investment Banks who facilitate the flow of capital from investors to issuers) to benchmark the relative credit risk of different debt issues, to set the initial pricing for individual debt issues they structure, to help determine the interest rate these issues will pay Who are the users of Credit Ratings?

Capital Market Participants: Enable corporations and governments to raise money in the capital markets. Instead of taking a loan from a bank, these entities sometimes borrow money directly from investors by issuing bonds or notes. Investors and other market participants may use the ratings as a screening device to match the relative credit risk of an issuer or individual debt issue with their own risk tolerance in making investment and business decisions. ‘The greater the credit risk, the higher return investors may expect for assuming that risk.’ Who are the users of Credit Ratings?

Businesses & Financial Institutions To assess counterparty risk - which is the potential risk that a party to a credit agreement may not fulfill its obligations. Issuers To help communicate (marketing) the relative credit quality of their debt issues To anticipate the interest rate to be offered on their new debt issues. ‘The more creditworthy an issuer or issue is, the lower the interest rate the issuer would typically have to pay to attract investors.’ Who are the users of Credit Ratings?

Credit Rating Methodology in India: Mandatory to have credit rating for all debt instruments. Quantitative and Qualitative factors are taken into consideration. Qualitative factors include quality of management, quality of human resources, quality of R&D activities, management efforts in improving overall efficiency of the organization etc For manufacturing companies, following analysis are conducted: ▫Business analysis ▫Financial Analysis ▫Managerial Evaluation

Ratings Process Conducting qualitative analysis (e.g. Competition and quality of management) Conducting quantitative analysis, which would include financial ratio analysis Meeting with the firm’s management Meeting of the committee in the rating agency assigned to rating the firm Notifying the rated firm of the assigned rating Opportunity for the firm to appeal or offer new information Disseminating the ratings to the public via the news media After the initial rating, the ratings agency monitors the firm and adjusts the rating as needed

What are the parameters which are assessed to arrive at a Credit Rating? Financial Profile – Company’s Revenues, Profits etc Business Profile –Market Share, Size of firm, Product acceptance Corporate Governance of Promoters / Management Profile – Management background Industry Profile – Industry growth, Relevance

For Financial companies, additional analysis are conducted.. Regulatory Environment analysis ▫Existing Regulations and their impact on the functioning of the company Fundamental analysis ▫Quality of Assets ▫Liquidity Management ▫Profitability and Financial Position

Business Analysis  Industry Risk o Existing and future demand o Number of Competitors o Expected level of competition in the future o Cyclical and seasonal factors  Market Share o Existing market share and expected changes o SWOT Analysis of the products Overall Efficiency o Labor productivity and labor turnover o Research and Development Activities  Legal aspects o Terms of Prospectus o Trustees and their responsibilities o Legal and political environment in which the company is operating o Legal cases pending against company or promoters

Financial Analysis Overall Accounting system Auditors certificates Taxation Provisions Inventory Valuation Depreciation Policies Existing and projected ▫Future profitability ▫Cash Inflows Ability to repay debt obligations Cost Structure

Financial Profile Objective assessment Past performance Balance sheet/P&L (Ratio) analysis Growth in top line, mid line and bottom line ▫Top line – Growth in sales – in tune with overall growth ▫Mid line - Growth in profit percentage (EBITDA) – Interest / tax / depreciation / other adjustments (operating profit..) ▫Bottom line – growth in net profit percentage Benchmarking with other players in the segment Examples Sales Profitability Current ratio What are the parameters which are assessed to arrive at a Credit Rating?

Financial Profile – Company’s Revenues, Profits etc Business Profile –Market Share, Size of firm, Product acceptance Corporate Governance of Promoters / Management Profile – Management background Industry Profile – Industry growth, Relevance

Financial Profile Objective assessment Past performance Balance sheet/P&L (Ratio) analysis Growth in top line, mid line and bottom line ▫Top line – Growth in sales – in tune with overall growth ▫Mid line - Growth in profit percentage (EBITDA) – Interest / tax / depreciation / other adjustments (operating profit..) ▫Bottom line – growth in net profit percentage Benchmarking with other players in the segment Examples Sales Profitability Current ratio What are the parameters which are assessed to arrive at a Credit Rating?

Business Profile Objective and Subjective Market Share Trend analysis Cash flow Future expectations Examples Credit allowed/availed Working capital cycle Price risk Product risk What are the parameters which are assessed to arrive at a Credit Rating?

Subjective Examples Transparency Management team biography History of defaults HR policies Technological/Managerial expertise Track record of group companies Capacity to raise funds Market report (reputation) Strategy for growth and expansions What are the parameters which are assessed to arrive at a Credit Rating? Managerial Evaluation Capabilities of the Management team are analyzed by applying various parameters

Industry Profile Cyclicality Global competitiveness Size of domestic market Technology competition Culture Future scope Financial status KSF (Key Success Factors) What are the parameters which are assessed to arrive at a Credit Rating?

How do the CRA’s earn revenue? Issuer Pays Model – The rating agencies are paid by those organizations whose debt they rate. May result in ‘Rating Shopping’ Subscriber Pays Model – The investor who wants to invest in certain securities or firms pays the rating agency to do a rating analysis Which model is better and which one results in Conflict of Interest??

Issuer-pays model vs. Investor-pays model?? AttributeIssuer PaySubscriber Pay Use of external dataThe issuer-pay model does not prohibit the use of external data, but concerns over conflicts of interest with the issuer leads to further concern that would limit data not used or approved by the issuer The subscriber-model openly promotes the use of external data and even provides a financial incentive for the CRA to cultivate such data, as the subscriber pays for such information and generally would be expected to pay for more data if found useful Availability of private data from issuer The issuer-pay model makes it especially easy for the issuer to share non-public data with the CRA. The data may include details that otherwise are hard or impossible for the CRA to identify. Due to conflicts of interest, it is expected that issuers share more optimistic data The subscriber-based model does not directly reward issuers for sharing confidential data. Although, some data can come from other parties or surveillance, this channel of information is limited in a pure subscriber- pay model

AttributeIssuer PaySubscriber Pay Conflicts of interestIssuers that pay CRAs create a conflict of interest for the CRA and generate moral hazard. In general, the issuer’s interests can contaminate the rating process. Moreover, there are a limited number of issuers, meaning that CRAs are especially concerned about issuer interests Subscribers also pose a conflict of interest, but since there are likely many more subscribers than issuers, it is not expected that one subscriber could contaminate the rating process with its interest. Subscribers may push for ratings that are favorable in sales of assets or in maintaining liquidity thresholds Transparency in data disclosure and methodology Due to the private relationship between the CRA and the issuer, the disclosure of data gained from the issuer is limited. Additionally, approaches in methodology taken may be influenced by the issuer, meaning that disclosure of methodology may also be difficult The subscribers generally expect disclosure of data and other opinions. Greater disclosure on methodology may not be expected when CRAs compete. However, CRAs may grow a business of providing additional stress-testing or subscriber- specific scenario analysis Issuer-pays model vs. Investor-pays model??

AttributeIssuer PaySubscriber Pay Stress-testingStress-testing is possible, provided the issuer can and does share the needed information on structured products Stress-testing is possible, but requires that the CRA acquire details on the underlying assets in a structured product. This level of detailed information may be difficult to acquire without the issuer’s cooperation Third-party evaluationThird party evaluation of a CRA rating on a structured product is hard, as disclosure of information is poor and reliance on confidential data from the issuer is high Subscriber-pay models are best operated when the data sold/shared can be used in a verification process. In such models, the subscriber builds confidence in the ratings and extends their use of those ratings Issuer-pays model vs. Investor-pays model??

Which model creates Conflict of Interest?? In the words of the President of S&P – Deven Sharma 'What an issuer-pays model offers is an ability to make the ratings available to the public free of charge. That creates more transparency in the capital markets, which is healthy for liquidity. Whereas if we move to an investor-pays model, the only way we can make money is by not making that information widely available and transparent.’ Also, issuers who want to raise capital obviously want their ratings to be as high as possible to reduce their financing costs. On the other hand, investors would be better off if, initially, the ratings are lower, so they can get better yields when the rating moves up. 'So if investors were to pay for ratings, they would want ratings to be somewhat lower and if there is a concentration of investors in fixed income - which there is - they could have undue influence. So, in an investor-pays model there can also be conflict of interest.'

Careers in CRA’s Analyst or Business Associates in Ratings division Research team Sales or Business Development Advisory/ Consulting

Questions?