SYNOPSIS ON

CORPORATE DEBT RATINGS: AN ANALYSIS OF METHODOLOGIES AND PRACTICES BY SELECT CREDIT RATING AGENCIES IN INDIA IN PARTIAL FULFILLMENT OF THE REQUIREMENT FOR THE DEGREE OF THE DOCTOR OF PHILOSOPHY IN THE AREA OF FINANCE

SUBMITTED BY ARJUN (ROLL NO-E-24)

COLLEGE: ASIA PACIFIC INST. OF MGT

SCOPE OF PRESENTATION
* * * * * * * * INTRODUCTION RATING PROCESS METHODOLOGY AND CRITERIA RATING SCALES NEW DEVELOPMENTS/ PRODUCTS LIMITATIONS? OBJECTIVES RESEARCH GAPS

* * * *

REVIEW OF LITERATURE RESEARCH METHODOLOGY EMPIRICAL FINDINGS PLAN OF STUDY

SECTION I

INTRODUCTION

DEFINITION
Rating is a tool that enables the investor to differentiate between debt instruments on the basis of their underlying credit quality. It is specific to a debt instrument and is intended as a grade, an analysis of the credit risk associated with the particular instrument. It is based upon the relative capability and willingness of the issuer of the instrument to service the debt obligations (both principal and interest) as per the terms of the contract. Rating of a security examines three factors - probability of default, the terms and character of the security and the degree of protection that can be granted to investors if the security issuer faces liquidation.

INSTRUMENTS FOR RATING

Long Term: Bonds/ debentures
Medium Term: Fixed Deposits/ bonds/ debentures Short Term: Commercial Paper/ Certificates of Deposits

FUNCTIONS OF CREDIT RATING

Provides the investor with risk-return analysis. Provides low cost and extensive information, esp. to lesser known companies to access the money and capital markets. Gives the investor a wider choice of instruments. Provides intermediaries with a tool to improve efficiency in the funds raising process. For the issuer, it lowers the cost of borrowing. Rating is also used as a marketing tool by the issuer. Greater credence to financial and other institutions. Reduction of cost in public issues. Assist the regulators in promoting transparency in the financial markets.

INTERNATIONAL RATING AGENCIES

Three leading global agencies - Standard and Poors, Moodys Investor Services and Fitch Ibca.

Global rating agencies evaluate sovereign risks, in addition to debt instruments.

CREDIT RATING IN INDIA

Emergence of credit rating in India: With the growth and globalisation of capital markets in 1980s led to a surge in demand for credit analysis by professional and independent bodies.
Four Credit Rating Agencies in India - CRISIL, ICRA, CARE and Fitch India.

SECTION II

RATING PROCESS

RATING PROCESS
Borrower/Issuer
Request for a Rating Document preparation

Rating Agency
Assign Analysts, conduct research Collection of Information

Plant visits and Management Meetings

Rating Committee assigns Rating

Communication of Rating to Issuers

Dissemination of Rating/Publication

Appeal

Surveillance/Annual Reviews

SECTION III

RATING METHODOLOGY AND CRITERIA

RATING METHODOLOGY

Business Risks

Financial Risks

Industry characteristics Market position

Demand drivers environment, competition bargaining power of suppliers

Operational Efficiency

New projects

Funding policies
Leverage, shareholder control,interest rates, currency exposure

Financial flexibility
Unutilised credit limits, group support management reputation, liquid investments

Management quality
Raw material, scale of operations, technology; location Organisation structure, information systems

RATING METHODOLOGY
Analysis of past financial performance Accounting quality

Cash flow analysis

Future cash flow adequacy Focus on key issues in rating

RATING CRITERIA
Group Support Coverage: Interest Coverage & DSCR Partial Guarantee as Credit Enhancement

Parent Company support

Capital Structure: Gearing & Net Cash Accruals to Total Debt Implications of buyback of shares

SECTION IV

RATING SCALE

LONG TERM
LONG TERM CRISIL ICRA CARE FITCH INDIA

AAA

LAAA

CARE AAA

AAA (Ind)

Highest Safety

AA

LAA+ LAA LAA-

CARE AA

AA (Ind)

High Safety

BBB (Inv.Grd)

BB

C D

LA+ LA LALBBB+ LBBB LBBBLBB+ LBB LBBLB+ LB LBLC+ LC LCLD

CARE A

A (Ind)

Adequate Safety

CARE BBB (Inv.Grd) CARE BB

BBB (Ind) (Inv.grd) BB (Ind)

M oderate Safety

Inadequate Safety

CARE B

B( ind)

Risk Prone

CARE C CARE D

C (Ind) D (Ind)

Substantial risk Default

MEDIUM AND SHORT TERM

M EDIUM TERM CRISIL ICRA CARE FITCH INDIA FAAA FAA M AAA M AA+ M AA M AAM A+ M A M AM B+ M B M BM C+ M C M CM D CARE AAA CARE AA tAAA (Ind) tAA ( Ind) Highest safety High Safety

FA

CARE A

tA (Ind)

Adequate Safety

FB

CARE B

tB (Ind)

Inadequate Safety

FC FD

CARE C CARE D

tC (Ind) tD (Ind)

Risk prone Default

SHORT TERM P1 A1+ A1 A2+ A2 A3+ A3 A4+ A4 A5 PR1 F1 (Ind) Highest Safety

P2 P3 P4 P5

PR2 PR3 PR4 PR5

F2 (Ind) F3 (Ind) F4 (Ind) F5 (Ind)

High Safety Adequate Safety Risk Prone Default

SECTION V

NEW DEVELOPMENTS

NEW DEVELOPMENTS
Corporate Governance Grading Foray into insurance sector. Rating of asset-backed securities.

Grading of construction companies.

Grading of Mutual Funds. Rating of Real Estate Grading of Health care

SECTION V1

LIMITATIONS

LIMITATIONS
Rating is issue-specific and not a performance evaluation of the rated company. It is not a recommendation to invest or not to invest in the instrument being rated. It is not an audit of the rated company, statutory or nonstatutory. It is not an indication of compliance with statutory or other requirements. Rating reports are confidential - the client only gets a final rating & a rationale but no further details of the analysis. Differences in rating among rating agencies - dual rating.

SECTION V11

OBJECTIVES OF THE RESEARCH

OBJECTIVES
Take cognizance of the research gaps

An examination of the frequency of changes made in the ratings by the two leading CRAs in India against the backdrop of changes in the performance of the issuer that has been rated.
Test the reliability of ratings assigned by the two leading CRAs in India on the basis of the actual default rates experience on long-term debt.

 The default statistics would be analyzed sector-wise, company-wise and period wise over a span of ten years. The objective would also be to do a comparative in- depth analysis of the credit rating procedures and practices being followed in India by the CRAs and globally to identify the differences in criteria of rating and the reasons for the same.

 To identify whether rating agencies are also watchdogs: can rating methodology be made more preemptive The objective of the study would be to evaluate the concept of awareness among investors and issuers on ratings to ensure reliability. To identify the accountability criteria for rating agencies. To study the impact of dual rating of issuers and its impact.

SECTION V111

RESEARCH GAPS

RESEARCH GAPS
Rating performance as indicators of default Failure of CRAs to warn investors of the defaults in advance. Rating process being reactive and not proactive The revenue models of the rating agencies needs to be examined since the rating is done at the behest of the issuers

 Governance of credit rating Ratings are forward looking assessments, not a forecast of future performance. The issuers have the option of going in for dual rating if the rating given by agency is not satisfactory.

SECTION 1X

REVIEW OF LITERATURE

REVIEW OF LITERATURE
Hickman (1958): Analyzed the large bond issues and found that riskier the bond, the higher the percentage of bonds that subsequently default. Atkinson and Simpson (1967): analyzed the trends in corporate bond quality from 1900 to 1965 and found that the default rate peaks coincide with the periods of economic distress. Altman and Nammacher (1985): Examined the default experience of corporate bonds over the period of 1970 to 1984. Bonds with a speculative grade rating at the time of issue subsequently had a much higher default rate than bonds that were initially of investment grade.

 Raghunathan and Verma (1992): Evaluated the rating given by Indias leading credit rating agency (CRISIL), and showed that the ratings are far too liberal by international standards and lack consistency. Sherwood(1996): The grades assigned did not reveal the investors problem of default risk. Ratings are altered only when agencies deem that sufficient changes have occurred Gupta, Gupta and Jain (2001): The study revealed that the major reason for lack of confidence among the retail investors in the bonds of private sector companies is the high default rate. The study concluded that the credit rating standards followed by the Indian credit rating agencies are rather lax, showing greater consideration to the issuers needs than for the investors interests.

SECTION X

RESEARCH METHODOLOGY

RESEARCH METHODOLOGY
The research methodology would comprise Primary and Secondary data analysis. Analysis would include statistical and nonstatistical techniques. Comparative analysis on the last ten years data of the two leading agencies on upgrades/downgrades sector-wise, companywise and period-wise.

 Taking a view of the investors on reliability of rating, by administering a questionnaire on several parameters relating to rating. A separate questionnaire would be administered to the companies which had gone in for dual rating in the last ten years and an analysis on the discrepancy in rating methodology and criteria. The questionnaire so designed would be in consultation with a leading rating agency along with one corporate and subsequently administered.

EMPIRICAL FINDINGS
Default statistics: sector-wise, company-wise and period-wise. Analysis of ratings prior to default Reasons for default Discrepancy in rating methodology being followed by the rating agencies in case of dual rating. Identification of the differences in rating process and criteria adopted by Indian and Global agencies. Surveillance of ratings Regulations, if any on the rating agencies.

SECTION X1

PLAN OF STUDY

PLAN OF STUDY
Chapter 1. Introduction on credit rating.

Chapter 2. Theoretical perspective to credit rating and overview.

Chapter 3. Literature Review Chapter4. Data and Research Methodology

Chapter5. Operating Performance and default indicators (sector-wise, period-wise and companywise).

 Chapter6.Comparative analysis of rating criteria and methodology between the two Leading Agencies (for companies following dual rating) Chapter7. Empirical Findings for default frequencies and dual ratings Chapter8. Rating Methodology of Indian Agencies- Comparative analysis with global agencies criteria Chapter 9. Issuers' perspective of Rating Agencies: A survey Chapter10. Bibliography