Before introducing credit rating, let me give you an example. Whenever we shop online from e-commerce websites such as Flipkart or Amazon, we look at the reviews of the product that we intend to buy. A higher review of the product gives us more confidence to buy it and a lower review of the product does vice-versa.
Similarly, when a company plans to borrow money from the public by issuing a debt instrument or it intends to avail any kind of loan from a bank, the credit rating agencies provide a rating opinion on the debt instrument of that company. The debt instrument can be bonds, term loans, working capital loans, non-convertible debenture, etc. Higher the credit rating assigned to the debt instrument, the more the confidence of the investor to invest in the debt instrument as the investment risk is low. Likewise, in the case of lending, a higher credit rating gives more confidence the banker has to lend money to the company.
So let’s understand the meaning of credit rating?
Credit rating is a professional opinion provided of credit risk associated with the debt instrument of an entity that seeks to borrow money. The entity can be private limited, public limited, large corporations, financial institutions, government, etc.
Credit rating is denoted by an alpha-numeric symbol such as AAA, AA, and BBB, etc.
It is also important to know that credit rating by means is not an investment opinion to buy, hold or sell any debt instrument.
6.2 – Who are the credit rating agencies in India and are they regulated?
In India, at present, there are seven credit rating agencies. Their names are as follows:
CRISIL
ICRA
CARE
BRICKWORK
INDIA RATINGS
SMERA
INFOMETRICS VALUATION AND RATING
All the credit rating agencies are being regulated by Securities Exchange Board of India (SEBI).
6.3 – Basic role of credit rating agencies
The most essential role of credit rating agencies (CRA) is to evaluate the credit risk of the debt instruments of an entity.
CRA is expected to provide an unbiased opinion on the credit risk. Although the opinion of CRA is not be considered investment advice, however, in case if a company plans to raise funds from issuance bond or debenture, investors in the financial market do look at the reports published by CRA to understand the credit risk involved in these debt instruments. As CRA has access to non-published information of the entities they rate which the investors in financial market don’t have access to.
Similarly, in the case of bank loan rating, the bankers have a detailed look at the rating opinion provided by CRA.
Therefore, the opinion provides by CRA carries a lot of importance, and to rate the debt instrument, the entities pay rating fees to the CRA.
6.4 – How frequently does the credit rating need to be assigned?
Once a company accepts the rating of its debt instrument provided by a CRA, then till the lifetime of the debt instrument, CRA needs to monitor the rating and conduct periodical reviews and intervene as and when required.
Let me illustrate with an example, let’s say HUL plans to raise funds by issuing a 10-year bond to the investors. Before raising funds from the public, HUL has to get its bond rated from a CRA. Once the rating assigned by the CRA is accepted by HUL, then till the maturity of the bond i.e. 10 years, CRA would continuously monitor HUL.
Periodic reviews would be generally done by CRA on annual basis. However, any significant event taking place in the economy or in any sector can have an impact on the credit profile of the company, which would require the CRA to monitor the scenario and provide necessary updates on the creditworthiness of the company as and when required.
6.5 - Understanding rating scale
While explaining the meaning of credit rating, I mentioned that the rating of the debt instrument is denoted by an alpha-numeric symbol such as AAA, AA, and BBB, etc.
So what does this symbol AAA, AA, BBB denote?
To understand these symbols let’s have a look at the table below:
So, if we carefully observe the above table, we can conclude that as we go down the rating scale from AAA to D, in each stage the credit risk associated with debt instruments increases, and if the rating goes to D, then the debt instruments has already defaulted or is expected to default soon.
In continuation with the rating scale, I would also like to point out that we do observe in newspapers, annual reports, business channels, etc. that a debt instrument of an entity has rated as AA+, BB-, BBB+, etc.
So what does + and – symbol denote in credit rating?
Basically, + and – are finer comparisons within the rating categories from AA to C. – symbol associated with rating does not have any negative connotations. In a true sense, rating of AA- rating is stronger compared to the BBB+ rating.
Under the similar rating category, let’s say AA category, AA+ is considered one notch higher than AA while AA- is one notch below AA.
This is how the rating scale would look after including + and – symbol look as shown in the below table:
Any debt instrument which is of longer term i.e. (more than 1 year) such as term loan, long-term debts, etc. are rated under the rating scale of AAA to D.
How does the rating scale of short term debt instrument look like?
After including + and – symbol to the rating of short term instruments, the rating scale would look as shown in the below table:
Further, debt instrument of an entity can be broadly classified into two categories namely Investment grade and speculative grade.
So what are investment grade and speculative grade rating?
The investment-grade rating signifies that the rating of the debt instrument is in the range of (AAA to BBB- for long term debt instrument, A1+ to A3- for short-term debt instrument). Therefore the debt instruments under this range are considered to have an adequate degree of safety with a low level of credit risk.
On the other hand, the speculative-grade rating is considered to be in the range of (BB+ and D for long term debt instruments, A4+ to D for short-term debt instruments). Hence, the debt instruments under this grade are considered to have a higher degree of credit risk. Generally, entities whose debt instruments are speculative-grade need to provide a higher coupon or higher interest rate to attract investors for the credit risk they bear.
6.6 - Basic Terminologies used in credit rating
Let’s understand the basic terminologies often used in a credit rating:
Upgrade/Downgrade/Reaffirmation
Even after assigning an entity with credit rating, it’s still subject to constant monitoring. The rating could shift due to some changes observed in the company's performance due to fluctuations arising from the business, industry, management, and financial profile of the company. When such situations occur, CRA takes an appropriate action to determine an upgrade, downgrade, or re-affirmation of the existing credit rating.
Upgrade
Whenever such changes have a positive impact on the company in the opinion of the CRA, an upgrade action is taken. For instance, in the case of Zuari Agro Chemicals Limited (ZACL), the existing rating has been upgraded to B (Stable) from D by ICRA on Apr 15, 2020, as the company started meeting its debt obligations for a period of more than three months.
Downgrade
On the other hand, when these changes could adversely affect the company in the opinion of the CRA, a downgrade action is taken. An example can be taken from Kanpur Fertilizers & Cement Pvt. Ltd (KFCL) as Brickworks has downgraded the rating from BBB- to D on Sep 18, 2019, as the company failed to repay its 1st installment due on the term loan.
Re-Affirmation
However, when these changes have a neutral impact on the company in the opinion of the CRA, the rating is reaffirmed. An ideal example could be the case of Havells India Limited (HIL) when CARE has reaffirmed both its long and short-term facilities on Sep 27, 2019, because the company continues to take into account strong brand image and market position in diversified product segments and consistently healthy financial performance.
Rating Outlook/Watch
CRA provides "Outlook" and "Watch" to formally alert investors about potential revisions in the credit rating of a company and it’s not necessary that these alerts have to come before each revision in ratings.
Outlook generally indicates the potential direction in which a rating is likely to move over a medium-term (defined as six months to two years). In determining a rating outlook, consideration is given to any changes in economic and/or fundamental business conditions. A rating outlook may be 'positive', 'stable' or 'negative'. A positive outlook indicates that an expected upgrade in the credit ratings on account of the above factors and vice-versa is applicable for negative outlook; a stable outlook indicates that the rating is likely to remain unchanged.
A rating watch indicates the expected direction of the rating movement in the short term and becomes applicable when there is an event, the credit implications of which are either unclear or not fully ascertainable quickly. These events include a proposed change in ownership control, a merger, a demerger, an acquisition, a sudden regulatory development, etc.
1. Positive watch indicates that once the credit uncertainty gets resolved, the rating is more likely to be upgraded.
2. Negative watch indicates that once the credit uncertainty gets resolved, the rating is more likely to be downgraded.
3. Developing watch indicates that the likely direction of the rating change is unascertainable based on the available information.
Suspension
A rating suspension does not imply that the entity is not servicing its debt obligations or that its financial position has deteriorated, but rather that it has failed to provide important information regarding, for example, its finances, liquidity or operations.
Withdrawal
Credit rating withdrawal happens mainly when requested to do so by the issuer. Secondarily, this happens when an issuer within a reasonable period has not or does not intend to disclose information that is material to a credible assessment of its creditworthiness. Apart from above-mentioned scenarios, it happens when an issuer ceases to exist because it has been taken over, merged with other entities, or has entered into bankruptcy. Last but not the least; it is applicable when the rated obligation has been repaid in full.
Chapter 7 – Credit Rating – (Part 2)
In the previous chapter, we got an overview of the basics of credit rating. In this chapter, we will understand the process of credit rating and we will try to understand how CRA arrives at credit rating for debt instrument of a company.
Let’s understand the credit rating process in detail:
7.1 Credit Rating Process
Suppose company ABC sells products in Flipkart, how do we come to know if its product is good enough? The simple answer will be like we will look at the peoples' reviews of that company's product. Similarly, the credit rating process also works. Let me explain. A reputed company runs a business and the company decided to further expand its business. But it doesn't have enough cash with it to do the same. What does the company do? It issues bonds in the market to raise fund from the public. To issue a bond in the market, it is SEBI's guideline that the company has a rating done from a credit rating agency. A non-rated company (bringing in the fear of the unknown for the creditors) would on the other hand face issues in raising bonds compared to a company rated by an external credit rating agency. This is done mainly to analyze whether there is a real requirement for the company to raise funds through bonds, how the overall performance of the company is, and helps the creditors to price the bond for the company with reference to the amount of credit risk that the creditors would be taking.
Following the SEBI guidelines, the company (Issuer) requests a Credit rating agency to rate its financial instrument (Bond). If the request is accepted by this rating agency, they enter into a contract agreement with each other. In some cases, rating fees are charged in the initial stage itself. The agency will request the issuer to provide necessary information relevant to the rating process. This may include background data, forecasts, risk reports or factual feedback on proposed analytical research and other communications.
Based on the demand and time frame of the credit report, analysts are assigned to look into this request. This team is responsible for completing the analysis necessary to bring the initial credit rating to the rating committee. They conduct a reasonable investigation of data accuracy and obtain reasonable verification of that information from independent sources such as bankers and auditors. Sometimes the issuers may choose not to share certain information with the credit rating agency. Once the verification is over, these analysts will have a detailed analysis of the company broadly based on the qualitative and quantitative factors. The relative importance of qualitative and quantitative components of the analysis varies with the type of issuer. Some of these come under the above factors: the business profile, operating segment and industry position, business risk, historical performance analysis, revenue and other driving factors in the past, and their consistency, capability of Cash flow generation, balance sheet analysis and liquidity profile, Financial ratios and peer analysis. If there are any more queries from the side of the analysts, they clear it with the issuer and its banker and auditor. If required analysts team may undertake a company site visit to perform its due diligence.
Once they prepare their findings, they submit it to their credit rating committee. The rating committee comprises experienced professionals who bring with them extensive experience in credit assessment. The rating committee assigns a rating after a thorough discussion on the report prepared by the analysts. After finalization of a rating at the rating committee, the rating decision is communicated to the issuer. Thereafter, a document that highlights the key reasons for assigning the rating is shared with the issuer. This is to help the issuer in understanding the key analytical factors that have been assessed for arriving at the rating decision.
If the issuer decides to accept the rating, it can do so by sending a letter of acceptance to credit rating agency as a proof of acceptance. On the other hand, if the issuer disagrees with the rating decision as it didn’t meet its expectation, it can request for a fresh look at the rating awarded. In the above case, the issuer needs to submit additional facts, data or new information to the analyst team, to be presented to the credit rating committee. Above information should be a solid proof for why they require a fresh appeal, and should specifically address areas that have been highlighted as factors constraining the rating given by the rating committee. After discussion in the rating committee on the information submitted, it may or may not change the rating, depending on the facts of the case. If the rating is not changed and issuer continues to disagree with the rating, then the issuer has an option of not accepting the rating. Recently, SEBI has mandated CRAs to publish such unaccepted credit ratings on their website. Hence following these guidelines, the unaccepted ratings shall be disclosed on CRA’s website.
In the case of accepted cases, ratings are broadcast to local and international media platform. Rating information is also posted in CRA’s website. This includes information about the company, rated instrument, rating assigned and outlook, etc. Moreover, there will be a periodic surveillance about the existing rating and updated rating will be published in CRA’s website. CRA continues to monitor the performance of the issuer and the economic environment in which it operates.
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