Credit Rating Agency
A credit rating agency is a private company that looks at the credit worthiness of a large-scale
borrower, such as a company or country. It effectively ranks the borrower, on their ability to pay off
their loan.
Credit Rating is a symbolic indication of the current opinion, regarding the capability of a corporate
entity to service its debt obligations in time, with reference to the instrument being rated. It enables
the investor to differentiate between debt instruments on the basis of their underlying credit
quality. In determining a rating, both qualitative and quantitative analyses are employed. The
judgment is qualitative in nature and the role of the quantitative analysis is to help make the best
possible overall qualitative judgment or opinion.
It establishes a link between risk and return. An investor or any other interested person uses the
rating to assess the risk-level and compares the offered rate of return with his expected rate of
return.
A credit rating is a way of assessing the creditworthiness of entities such as individuals, groups,
businesses, non-profit organizations, governments, and even countries. Special credit rating agencies
analyze their financial risk to see whether or not these borrowers will be able to pay back loans on
time.
The credit rating agencies compile this rating using a detailed report that takes into consideration
various factors such as lending and borrowing history, ability to repay the debt, past debts, future
economic potential, and more.
A rating is specific to a debt instrument and is intended to grade different such instruments in terms
of credit risk and ability of the company to service the debt obligations as per terms of contract
namely - principal as well as interest. A rating is neither a general purpose evaluation of a corporate
entity, nor an overall assessment of the credit risk likely to be involved in all the debts contracted or
to be contracted by such entity.
A good credit rating improves credibility and indicates a good history of paying back loans on time in
the past. It helps banks and investors decide about approving loan applications and the rate of
interest offered.
An agency may rate the creditworthiness of issuers of debt obligations, of debt instruments, and in
some cases, of the servicers of the underlying debt, but not of individual consumers. The debt
instruments rated by CRAs include government bonds, corporate bonds, CDs, municipal bonds,
preferred stock, and collateralized securities, such as mortgage backed securities and collateralized
debt obligations
USES OF CREDIT RATING
Credit rating is extremely important as it not only plays a role in investor protection but also benefits
industry as a whole in terms of direct mobilization of savings from individuals. Rating also provide a
marketing tool to the company and its investment bankers in placing company’s debt obligations
with a investor base that is aware of, and comfortable with, the level of risk. Ratings also encourage
discipline amongst corporate borrowers to improve their financial structure and operating risks to
obtain a better rating for their debt obligations and thereby lower the cost of borrowing. Companies
those get a lower rating are forewarned, as it were and have the freedom, if they desire, to take
steps on their financial or business risks and thereby improve their standing in the market.
For Investors, Investors most often use credit ratings to help assess credit risk and to compare
different issuers and debt issues when making investment decisions and managing their portfolios.
Individual investors, for example, may use credit ratings in evaluating the purchase of a municipal or
corporate bond from a risk tolerance perspective. Institutional investors, including mutual funds,
pension funds, banks, and insurance companies, often use credit ratings to supplement their own
credit analysis of specific debt issues. In addition, institutional investors may use credit ratings to
establish thresholds for credit risk and investment guidelines. A rating may be used as an indication
of credit quality, but investors should consider a variety of factors, including their own analysis.
For Issuers, The market places immense faith in opinion of credit rating agencies, hence the issuers
also depend on their critical analysis. This enables the issuers of highly rated instruments to access
the market even during adverse market conditions. Credit rating provides a basis for determining the
additional return (over and above a risk free return) which investors must get in order to be
compensated for the additional risk that they bear. The difference in price leads to significant cost
savings in the case of highly rated instruments.
For Intermediaries, Rating is useful to Intermediaries such as merchant bankers for planning, pricing,
underwriting and placement of the issues. Intermediaries like brokers and dealers in securities use
rating as an input for monitoring risk exposures. Merchant bankers also use credit rating for pre-
packaging issues by way of asset securitization/ structured obligations.
Investment bankers help to facilitate the flow of capital from investors to issuers. They may use
credit ratings to benchmark the relative credit risk of different debt issues, as well as to set the initial
pricing for individual debt issues they structure and to help determine the interest rate these issues
will pay. Investment bankers may look to a rating agency’s criteria when seeking to understand that
rating agency’s approach toward rating different debt issues or different tiers of debt.
Investment bankers may also serve as arrangers of debt issues. In this capacity, they may establish
special purpose entities that package assets, such as retail mortgages and student loans, into
securities or structured finance instruments, which they then market to investors.
For Regulators, The Reserve Bank of India (RBI) prescribes a number of regulatory uses of ratings.
The RBI requires that a NBFC must have minimum investment grade credit rating if it intends to
accept public deposits. As per money market regulations of the RBI, a corporate must get an issue of
CP rated and can issue such paper subject to a minimum rating. SEBI has also stipulated that ratings
are compulsory for all public issue of debentures. SEBI has also made mandatory for acceptance of
public deposit by Collective Investment Schemes.
How Credit Rating Works
A loan is a debt—essentially a promise, often contractual, and a credit rating determines the
likelihood that the borrower will be able and willing to pay back a loan within the confines of the
loan agreement, without defaulting. A high credit rating indicates a high possibility of paying back
the loan in its entirety without any issues; a poor credit rating suggests that the borrower has had
trouble paying back loans in the past and might follow the same pattern in the future. The credit
rating affects the entity's chances of being approved for a given loan or receiving favourable terms
for said loan.
Credit ratings apply to businesses and government, while credit scores apply only to individuals.
Credit scores are derived from the credit history maintained by credit reporting agencies. An
individual's credit score is reported as a number, generally ranging from 300 to 850. Similarly,
sovereign credit ratings apply to national governments, while corporate credit ratings apply solely to
corporations.
A short-term credit rating reflects the likelihood of the borrower defaulting within the year. This type
of credit rating has become the norm in recent years, whereas in the past, long-term credit ratings
were more heavily considered. Long-term credit ratings predict the borrower's likelihood of
defaulting at any given time in the extended future. Credit rating agencies typically assign letter
grades to indicate ratings. Standard & Poor’s, for instance, has a credit rating scale ranging from AAA
(excellent) to C and D. A debt instrument with a rating below BB is considered to be a speculative
grade or a junk bond, which means it is more likely to default on loans.
FUNCTIONS/IMPORTANCE OF CREDIT RATING
1. Provides unbiased opinion:
An independent credit rating agency is likely to provide an unbiased opinion as to relative capability
of the company to service debt obligations because of the following reasons:
i. It has no vested interest in an issue unlike brokers, financial intermediaries.
ii. ii. Its own reputation is at stake.
2. Provides quality and dependable information:
A credit rating agency is in a position to provide quality information on credit risk which is more
authenticated and reliable because:
i. It has highly trained staffs that have better ability to assess risk.
ii. ii. It has access to a lot of information which may not be publicly available.
3. Provides information at low cost:
Most of the investors rely on the ratings assigned by the ratings agencies while taking investment
decisions. These ratings are published in the form of reports and are available easily on the payment
of negligible price. It is not possible for the investors to assess the creditworthiness of the companies
on their own.
4. Provide easy to understand information:
Rating agencies first of all gather information, then analyse the same. At last these interpret and
summarise complex information in a simple and readily understood formal manner. Thus in other
words, information supplied by rating agencies can be easily understood by the investors. They need
not go into details of the financial statements.
5. Provide basis for investment:
An investment rated by a credit rating enjoys higher confidence from investors. Investors can make
an estimate of the risk and return associated with a particular rated issue while investing money in
them.
6. Healthy discipline on corporate borrowers:
Higher credit rating to any credit investment enhances corporate image and builds up goodwill and
hence it induces a healthy/ discipline on corporate.
7. Formation of public policy:
Once the debt securities are rated professionally, it would be easier to formulate public policy
guidelines as to the eligibility of securities to be included in different kinds of institutional port-folio.
FACTORS CONSIDERED IN CREDIT RATING
1. Issuer’s ability to service its debt.
For this credit rating agencies calculate
a) Issuer Company’s past and future cash flows.
b) Assess how much money the company will have to pay as interest on borrowed funds and how
much will be its earnings.
c) How much are the outstanding debts?
d) Company's short term solvency through calculation of current ratio.
e) Value of assets pledged as collateral security by the company.
f) Availability and quality of raw material used, favourable location, cost advantage.
g) Track record of promoters, directors and expertise of the staff.
2. Market position of the company. What is the market share of various products of the company,
whether it will be stable, does the company possess competitive advantage due to distribution net-
work, customer base research and development facilities etc.
3. Quality of management. Credit rating agency will also take into consideration track record,
strategies, competency and philosophy of senior management.
4. Legal position of the instrument. It means whether the issued instrument is legally valid, what are
the terms and conditions of issue and redemption; how much the instrument is protected from
frauds, what are the terms of debenture trust deed etc.
5. Industry risks. Industry risks are studied in relation to position of demand and supply for the
products of that industry (e.g. cars or electronics) how much is the international competition, what
are the future prospects of that industry, is it going to die or expand?
6. Regulatory environment. Whether that industry is being regulated by government (like liquor
industry), whether there is a price control on it, whether there is government support for it, can it
take advantage of tax concessions etc.
7. Other factors. In addition to the above, the other factors to be noted for credit rating of a
company are its cost structure, insurance cover undertaken, accounting quality, market reputation,
working capital management, human resource quality, funding policy, leverage, flexibility, exchange
rate risks etc
CREDIT RATING PROCESS
In India credit rating is done mostly at the request of the borrowers or issuer companies. The
borrower or issuer company requests the credit rating agency for assigning a ranking to the
proposed instrument. The process followed by most of the credit rating agencies is as follows:
1. Agreement. An agreement is entered into between the rating agency and the issuer company. It
covers details about terms and conditions for doing the rating.
2. Appointment of analytical team. The rating agency assigns the job to a team of experts. The team
usually comprises of two analysts who have expert knowledge in the relevant business area and is
responsible for carrying out rating.
3. Obtaining information. The analytical team obtains the required information from the client
company and studies company's financial position, cash flows, nature and basis of competition,
market share, operating efficiency arrangements, managements track cost structure, selling and
distribution record, power (electricity) and labour situation etc.
4. Meeting the officials. To obtain clarifications and understanding the client's business the analytical
team visits and interacts with the executives of the client.
5. Discussion about findings. After completion of study of facts and their analysis by the analytical
team the matter is placed before the internal committee (which comprises of senior analysts) an
opinion about the rating is taken.
6. Meeting of the rating committee. The findings of internal committee are referred to the “rating
committee" which generally comprises of a few directors and is the final authority for assigning
ratings.
7. Communication of decision. The rating decided by the rating committee is communicated to the
requesting company.
8. Information to the public. The rating company publishes the rating through reports and the press.
9. Revision of the rating. Once the issuer company has accepted the rating, the rating agency is
under an obligation to monitor the assigned rating. The rating agency monitors all ratings during the
life of the instrument.
CONCLUSION
Credit rating agency should specify the rating process and file a copy of the same with SEBI for
record and also file with SEBI any modifications or additions made therein from time to time. It
should in all cases follow a proper rating process. Credit rating agency is required to have
professional rating committees, comprising members who are adequately qualified and
knowledgeable to assign a rating. All rating decisions, including the decisions regarding changes in
rating, should be taken by the rating committee. Credit rating agency should be staffed by analysts
qualified to carry out a rating assignment. Credit rating agency should inform SEBI about new rating
instruments or symbols introduced by it. Credit rating agency, while rating a security should exercise
due diligence in order to ensure that the rating given by the credit rating agency is fair and
appropriate. A credit rating agency should not rate securities issued by it. Rating definition, as well as
the structure for a particular rating product, should not be changed by a credit rating agency,
without prior information to SEBI. A credit rating agency should disclose to the concerned stock
exchange through press release and websites for general investors, the rating assigned to the
securities of a client, after periodic review, including changes in rating, if any.
