Credit Rating - All you need to know

Definition

A credit rating is a quantitative assessment of a specific debt instrument, most commonly a bond that has been issued by a company. Every bond transaction has two counterparties to a deal – the borrower (or the company) and the lender (usually a bank). An associated credit rating helps the lender determine the

• a) Risk of default to the instrument – Higher the rating, lower the risk
• b) Rate of interest – Higher the credit rating of the borrower, lower is the risk of default. So, the lender charges a lower rate of interest to the borrower.

Significance of credit ratings and the issuer

In India, there are six rating agencies registered under SEBI (Securities and Exchange Board of India). These are CARE, ICRA, CRISIL, India Ratings, SMERA and Brickwork Ratings.

Of these, S&P owns CRISIL, the largest credit rating agency in India;Moody’s is the parent of ICRA andFitch Ratingsmaintains India Ratings. All of them are globallyrecognised credit rating companies.

Rating Scale

When it comes to long term ratings, the scale for all credit rating agencies is broadly similar. Tabled below are the rating symbols and their corresponding description.

AAA is the rating assigned to instruments that carry the lowest credit risk. The reason is that it has the highest degree of certainty when it comes to servicing its debt obligations. On the other hand, D is a rating given to an instrument that has either defaulted or is likely default.

There is an added sign – “+” or “-“attached to grades from AA to C, which reflects the comparative standing of the instrument within the category. For example, a bond that is rated AA+ is comparatively safer than AA-, although both of them fall within the same “High Safety” category.

The rating symbols for short term ratings are slightly different from those above. CRISIL, for example, has A1, A2, A3, A4, and D as the credit rating symbols for short term debt. “+” and “-“ signs denote the relative safety within a category.

Difference and linkages between short-term and long-term ratings

Long term ratings are a measure of the probability of default of instruments and associated entities that have a maturity beyond one year. It tries to predict the ability of the borrower to repay contractual liabilities over the long-term period.

Short term ratings are a measure of the probability of default for instruments that have a maturity period of one year or less, from the date of issuance. Examples of short-term instruments are certificates of deposit, commercial paper, and short-term debentures.

Short term ratings have a linkage with the long-term credit rating of an entity. That’s because while short term ratings are for instruments which expire within a year, these can be an ongoing fund-raising exercise for an entity. The long-term ratings in the meanwhile reflect the ability of entities to access funding by monitoring its overall credit profile.

Relevance to Mutual Funds

Bonds represent loans that are made to a borrower by the lender, also referred to as fixed-income instruments. That’s because they generate a fixed income over their life by way of interest payments at a fixed period. The interest payments are also called coupon payments.

As bonds come with a pre-determined payment plan as well as fixed coupons, they are attractive to investors who are seeking investment returns from the financial markets without the need to take risks on the equity markets. Equity, as an asset class,can produce very high returns over the long term, but it also comes with associated risks and volatility. For conservative investors, mutual funds that invest in bonds are the preferred medium of investment rather than funds that invest primarily in the equities markets.Individual investors (who are approaching retirement) or corporates who want to deploy their cash reserves without taking a risk on their principal investment fall in this bucket. In-fact, as opposed to equity mutual funds, debt funds (or fixed income funds) that invest in bonds are a much larger market overall. That’s because large corporates that generate crores in cash from business income invest in debt funds to generate returns that are higher than fixed deposits with a high level of security.

The following table illustrates the categorisation of debt mutual funds

These debt funds have various investment objectives - like those based on duration or specific industry segments like banking, PSU and others. Besides, all debt mutual funds have stringent policies with regards to investing in bonds based on their credit ratings. As these funds attract investors who have a low-risk appetite, it is paramount for these funds to invest in safer fixed income instruments.

Funds disclose risk with various ratios. However, an important metric is also the credit rating profile of its current portfolio. Let’s see this with an example -

Below is the credit rating profile of SBI Magnum Income Fund – one of the funds that belong to the medium- and long-term duration category.

Analysis

• The portfolio of the fund remains heavily invested into government-issued bonds – signified here as Sovereign. 52.62% of the portfolio comes under the category ofSovereign. Government bonds have the highest level of safety amongst all bonds, as the government of India secures them.
• AAA forms 13.11% of the portfolio, which is the highest credit rating assigned to bonds.
• Almost 32% of the total portfolio investments are in AA bonds.

This portfolio profile is essential for an investor as it gives a view of the safety of the portfolio.

Credit Rating Changes

A change in the credit rating of any company is a significant event. An upgrade is a sign of renewed confidence in the ability of the company to service its financial obligations. A downgrade signifies the firm’s ability to service its debts has deteriorated. As a consequence of this change, a listed company is very likely to see its share prices going down as investors turn bearish. Similarly, it becomes more difficult and expensive for the company to raise further debt. Hence, it is paramount for listed firms to maintain or improve their credit ratings over the long term.

The Credit Rating Process

The underlying objective of the credit rating exercise is to assess the cash generation capabilities of a corporate and determine if it meets all its upcoming financial obligations, even in adverse scenarios. To achieve this, credit rating agencies carry out an extensive fundamental and business analysis of the company.

Following are some of the primary tasks CR agencies undertake before they could issue a credit rating to a firm

• 1. Industry and Competitor Analysis.
• 2. Business and Financial Risk Analysis.
• 3. Due diligence. These are carried out by interacting with the firm’s stakeholders like auditors, suppliers, and customers.
• 4. Management and Operational Analysis.
• 5. Any other analysis that is relevant to determine the firm’s financial position and its long-term future accurately.

The research team of the rating agency then presents this analysis to a rating committee that finalises the rating and releases them in the public domain. A company can appeal a rating if it is not satisfied with it, which could lead to a re-evaluation. On the broad front, a rating agency is neutral in its assessment of a firm, without any say from the company itself.

SEBI Regulations and Rating Agencies

SEBI governs all credit rating agencies in India, and they come under the SEBI Credit Rating Agencies Regulations of 1999. These regulations provide the eligibility criteria for registration of credit rating agencies, requirements for a proper rating process, monitoring and review of the ratings, avoidance of conflict of interest, and inspection of the agencies.

SEBI regulations require all credit instruments to be credit rated over their entire lifetime. Over the last few years, SEBI has taken steps to make the credit rating process stronger by initiating some of the following steps

• Mandatory for firms to disclose any information that it shares with the lender available to the credit rating agencies.
• Publicly disclose information when a company does not cooperate with a credit rating agency.

Credit ratings face an inherent conflict of interest the world over. In India, some companies pay to get credit rated. Additionally, there is tough competition between credit rating firms for more business, which inherently introduces a conflict in the process. SEBI has consistently tried to minimise this by penalising credit rating agencies that have not been able to predict credit events in advance. Recently, the IL&FS fiasco highlighted this, where the credit rating agencies continued to rely on management provided information to retain a AAA (least risky) rating to the firm’s NCDs even as they defaulted.

Conclusion

Credit Rating is an essential indicator of the creditworthiness of a borrower. Lenders use this information to determine lending rates to companies. For mutual funds, portfolio risk comprises of their exposure to bonds of varying credit profiles. Hence, for investors, the credit rating profile of a fund is one of the key metrics to assess safety before investment. As credit ratings have to monitor companies on an ongoing basis, changes become critical events for funds as well as investors.