Credit Rating

By- Rahul Jain

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What is a credit rating?What is a credit rating?

A credit rating is an opinion on the relative degree of risk associated with timely payment of interest and principal on a debt instrument. A simple alphanumeric symbol is normally used to convey a credit rating.

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Credit rating is an input for Credit rating is an input for decision makingdecision making

A credit rating is not a recommendation to buy, hold or sell a debt instrument. A rating is one of the inputs that is used by investors to make an investment decision.

Investors also look at the returns being offered on the debt instrument. Normally investors expect higher returns for lower rated instruments to compensate for the increased risk profile. Rating agencies do not comment on the return being offered on a debt instrument. Also, investors use several other factors like level of portfolio diversification and liquidity levels of the instrument etc. in making investment decisions.

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Need of Credit Need of Credit ratingrating

SOURCE OF FUNDS USE OF FUNDS

Depositors Borrowers

Bank provides liquidity Bank assumes credit risk Bank undertakes credit assessments

Bank

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Need of Credit Need of Credit ratingrating

SOURCE OF FUNDS USE OF FUNDS

Investors Issuers

Market provides liquidity Investors assume credit risk Credit rating service provides measure of credit risk

MARKET

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Asian Debt Market Activity - 2002Aggregate of Cross-Border Bond, Domestic Bond and Loan Market

Source Thomson Financial

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000US$ (m)

Total Debt Market

Domestic Bonds

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IssuesIssues1. Transparency and disclosure2. Protection of creditor rights3. Global scale vs National scale

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SEBI-RegulatorSEBI-RegulatorThe capital market regulator regulates

rating agencies in most regions. In India, the capital markets regulator, the Securities and Exchange Board of India (SEBI), regulates the rating agencies in the country. SEBI laid down an extensive set of regulations for rating agencies in 1999.

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Why do ratings change?Why do ratings change?

Ratings are assigned based on certain expectations and assumptions about variables that impact the issuer’s performance.

These variables are either company-specific factors or factors relating to the business environment. Rating agencies use their best professional judgment on these factors while assigning the rating. However, these variables can change significantly over a relatively short time-frame, especially in emerging markets, causing the rated entities’ performance to deviate materially from expectations. This changes their future debt repayment capabilities and is reflected in their changed ratings.

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Rating ProcessRating Process

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Global Vs. National Rating Global Vs. National Rating ScalesScales

Global Scale

• Include relevant sovereign and country risk considerations

• Creditworthiness based on a global comparative analysis

• Both foreign and local currency credit options

National Scale

• Exclude direct sovereign risks of other country risk factors that affect all local obligators

• Relative creditstanding within a given country

• Local currency credit opinions

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Standard & Poor’s Asia-Pacific Network – 2003

Standard & Poor’s *Hong KongMelbourneSeoulSingaporeSydneyTokyo

* Staff - 320

AffiliatesCRISIL (Mumbai)PEFINDO (Jakarta)PhilRatings (Manila)TRC (Taipei)

Average Cumulative15-Year Default Rates Average Cumulative15-Year Default Rates (%)(%)

Source: Standard & Poor’s

0.671.30

2.30

4.27

24.51

27.83

60.70

0

10

20

30

40

50

60

70

AAA AA A BBB BB B CCC