Credit Rating
What is Credit Rating and how is it determined?
The Credit Rating is an assessment about the probability, that an organization will fail to repay the principal and interest of the debt it has taken. The ratings are given on a pre-defined scale, which allows easy comparison of the risk associated with different debt instruments.
The Credit Ratings can be assigned to any organization like Government, Company, Business Trust etc. These are usually assigned for debt instruments and not for equity instruments. So, the ratings represent the credit worthiness of the organization issuing the debt.
The ratings represent the opinion of the Credit Rating Agency and they do not provide any guarantee about the riskiness or safety of the investment. The investors can use the assigned ratings to judge the risks associated with different investment options.
Credit Rating process
The ratings are determined by doing an evaluation of the strengths and weaknesses of the entity which is issuing the debt instrument. The factors like assets, liabilities, operational efficiency, quality of earnings, past credit history etc. are used to judge the financial position of the organization.
In addition, other external parameters like macro-economic factors, political stability, laws and regulations etc. are taken into account as well. All Credit Rating agencies have their own analysis criteria, where they give different weightage to the parameters which they consider as important. The scoring on these parameters is used to compute the final rating.
A good Credit Rating indicates that the borrower will be able to meet the debt obligations without running into any financial difficulties. On the other hand, a bad rating is a signal that the borrower is likely to face difficulties in repayment of the debt. So, the long-term ratings are used to characterize the debt instrument as Investment Grade or Speculative Grade.
Credit Rating Scale
The scope of the rating determines the scale that will be used to analyze the debt instrument. For example, if an Indian company is issuing bonds in international markets, then the bonds need to be rated at a global level. The following three levels are often used to define the scope:
Global
Debt instrument is compared with other debt instruments around the world. So, the countries with a strong economy, political stability, less debt etc. will get the best rating.
Regional
Debt instrument is compared with other debt instruments within a specific region.
National
Debt instrument is compared with other debt instruments within a country. Typically, the debt securities issued by the Central Government get the highest rating in this case.
Credit Rating symbols
The maturity of the debt instrument is used to determine the rating symbols that will be used. There are two main scales defined: Short-term rating scale (For debt instruments with original maturity of one year or less) and Long-term rating scale (For instruments with original maturity greater than one year).
In the table below, we give a list of standard rating symbols defined by SEBI which are used by all rating agencies in India. The ratings ‘AAA’ and ‘A1’ represent the safest investment options with the least probability of default. As we move down the table, the riskiness of the investment increases. A rating of ‘D’ means that the borrower is expected to default on the repayment.
| Long-term Credit Rating Scale | Short-term Credit Rating Scale |
|
AAA |
A1 |
|
AA |
A2 |
|
A |
A3 |
|
BBB |
A4 |
|
BB |
D |
|
B |
|
|
C |
|
|
D |
To view the complete list of symbols and definitions used for Credit Rating in India, refer: Credit Rating Scale.
Modifiers in Credit rating
In addition to the above symbols, the ratings are usually accompanied with a ‘+’ or ‘-‘ sign. These are used for comparison of instruments that fall in the same Credit Rating. For example, hundreds of instruments could be rated ‘AA’. The comparators: ‘+’ or ‘-‘ can indicate the ranking of similar instruments within the ‘AA’ category.
Example:
The ‘BB’ rating can be further broken down into ‘BB+’, ‘BB’, ‘BB-‘. In this case, ‘BB+’ is considered safer than ‘BB’, which in turn is safer than ‘BB-‘.
Credit Rating outlook
Many times, the ratings issued by the agency also include a rating outlook. The outlook indicates the direction in which the rating could possibly move in the next one to two years. The outlook is not assigned for ‘C’ and ‘D’ category instruments. The three possible outlooks have been defined in the table below.
| Rating outlook | Definition |
|
Positive |
A material probability that the rating could be upgraded in the next one to two years. |
|
Stable |
A material probability that the rating will remain unchanged in the next one to two years. |
|
Negative |
A material probability that the rating could be downgraded in the next one to two years. |
Ratings placed on Watch
The assigned Credit rating could be placed ‘on watch’ if there is a sudden, material change in the financial position of the borrower. Some situations where this could happen are: Mergers and Acquisitions, outcome of litigations, penalties and actions taken by regulators etc.
When a rating is placed on watch, it could be upgraded or downgraded based on how the situation materializes. So, this is usually an indicator of an uncertainty due to the event, but it is also possible that the ratings get re-affirmed.
Sample Credit Ratings
Let us look at some examples of how a rating is communicated.
‘MyCRA BBB+ Negative‘
Here, ‘MyCRA’ is the (hypothetical) name of the rating agency
‘BBB’ is the rating symbol (long-term rating)
‘+’ is the Modifier / comparator
‘Negative’ is the outlook on this rating
‘MyCRA A1‘
Here, ‘MyCRA’ is the (hypothetical) name of the rating agency
‘A1’ is the rating symbol
No outlook, as this is a short term-rating
‘MyCRA AA- (SO) Stable‘
Here, ‘MyCRA’ is the (hypothetical) name of the rating agency
‘AA’ is the rating symbol (long-term rating)
‘-‘ is the Modifier/comparator
‘(SO)’ is an indicator that the instrument being rated is a Structured Finance Obligation
‘Stable’ is the outlook on this rating
Validity of Credit Ratings
The rating of the debt is not a one-time exercise. The Credit Rating Agencies keep track of the financial position of the organization, and if the debt repayment might be affected, then the Credit Rating of the debt could be changed.
The rating is an important parameter as the safety of the investment governs the borrowing cost and the Yield to Maturity. As the rating of the debt instrument changes, the yield from the instrument will also increase or decrease.
The rating agency needs constant access to financial documents from the borrower. But if the borrower does not provide the information in relevant time, the rating agency does the analysis using the available information. In such a case, the rating symbol is accompanied with the comment: ‘Issuer did not co-operate; Based on best available information’.
Upgrade and Downgrade of ratings
It is possible that the financials of the organization improve or degrade, few months after issuing the debt instrument.
Example: Suppose, a company issues bonds which are rated ‘BBB’ and these have a maturity of ten years. Let us assume that four years later, the company starts making huge losses. The rating agency feels the financials are not strong enough to repay the debt and it downgrades the rating of the bonds to ‘BB’.
In the above example, the bonds turned into Junk bonds due to poor performance of the company. Similarly, if the financials of the company improve dramatically, the ratings could be upgraded.
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