Intro to Credit Rating Agencies

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Introduction toCredit Rating Agencies

Financial Services Industry Training

Saunders Learning Group, LLC, Andover, KS

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1. Meaning and Definition2. Role and Function of Credit Rating Agencies 3. Moody's, Standard & Poor's, Fitch Ratings 4. Rating Methodology5. Advantages of Credit Rating6. Disadvantages of Credit Rating

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Topics


Basic Terms


Credit Rating

A credit rating estimates the credit worthiness of an a financial security, a corporation, local government or even a country.

It is an evaluation made by credit reporting agency of a risk of buying into a specific security offering and based on a number of factors.

Credit ratings are calculated from financial history and current assets and liabilities.

Typically, a credit rating tells a lender or investor the probability of the subject being able to meet payment requirements for interest and principal repayment.


What is A Credit Rating

An opinion on the issuer’s capacity to meet its financial obligations on a particular issue in a timely manner, for example long-term bonds:


Distinction Between Credit Rating and Reporting

A Credit Rating Agency (CRA) is a company that is responsible for assessing the financial strength of a company or government entity. This includes domestic and foreign companies. The main area that a credit rating agency focuses on is the ability of the company or government entity to meet the interest and principle payments on their debts and bonds. A credit rating agency is different from a credit reporting agency.

A credit reporting agency is responsible for compiling financial data that is necessary for loan decisions.

A credit rating agency does all the statistical assessments that are involved in placing a rating on a company or organization’s credit history..

A credit rating agency is responsible for providing investors with information about an organization’s creditworthiness.

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Meaning and Definition

A Credit Rating issued by a credit rating agency is an assessment of the credit worthiness of individual financial securities (For example, a bond) and debt issued by corporations, government issued securities or even a country’s ability to repay debt.

Credit Ratings are assigned by rating agencies to companies and debt instruments, are designed to gauge the likelihood that a company will default on its obligations to creditors. Thus, they give investors a rough idea of the risk associated with loaning money to the entity being rated.

Credit ratings are forward-looking opinions about credit risk. It express the agency’s opinion about the ability and willingness of an issuer, such as a corporation or state or city government, to meet its financial obligations in full and on time.

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Uses of credit ratings

Credit ratings are critical to the activities of securities markets, as they are depended on to create and manage investment portfolios, the pricing of new securities, trading of securities, financial contracts (and loans) and for some financial institutions to meet regulatory requirements.

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CreditRatings

BuildingPortfolios

Pricing

Contracts

RegulatoryRequirements

Trading


Module 1 Role and Function of Credit

Rating Agencies

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Credit Reporting Agencies

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Function

Example Activities

Example Companies

Provides investors with unbiased reviews and opinion as the credit risk of various securities.

Performs credit and risk analysis to produce ratings.Maintains databases of credit and risk information on companies and financial

securities.Provides unbiased opinion. An independent credit rating agency provides an

unbiased opinion as to relative capability of a company to service debt obligations.Provides quality and dependable information on investment and credit risk which is

more authenticate and reliable.Provides information at low cost or no cost to investors. Investors rely on the ratings assigned by the ratings agencies while taking

investment decisions. Ratings are published in the form of reports and are available easily on the payment

of negligible price or free of charge depending on the arrangements in specific countries.

A.M. Best; Credit Analysis & Research (CARE), India; Dominion Bond Rating Service, Canada; Fitch Ratings, U.S. & UK; Investment Information and Credit Rating Agency (ICRA), India, Moody’s, S&P. Complete list @: http://www.defaultrisk.com/rating_agencies.htm

http://www.defaultrisk.com/rating_agencies.htm

http://www.defaultrisk.com/rating_agencies.htm


Functions of a Credit Rating Agency

Provide easy to understand information: Rating agencies gather information, then analyze information to interpret and summarize complex information in a simple and readily understood manner.

Provide basis for investment: An investment rated by a credit rating enjoys higher confidence from investors. Investors can make an estimate of the risk and return associated with a particular rated issue while investing money in them.

Healthy discipline on corporate borrowers: Higher credit rating to any credit investment makes the financial instrument (bond, mortgage security) more attractive to investors. Corporations can borrow money more cheaply if they maintain high credit ratings on their debt.

Formation of public policy: Once the debt securities are rated professionally, it would be easier to formulate public policy guidelines as to the eligibility of securities to be included in different kinds of institutional portfolios.

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How Credit Ratings Are Established

A credit rating agency collects a variety of data, analyses it and produces a recommended credit rating, once reviewed, it distributed to potential investors.

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Industry / Macro Economic Data

Adjusted Financial Statement Data

Other Company Specific Data

Analysis

Rating Committee Package and Recommendation


Industry methodologies…

The typical methods used by credit rating agencies to compare a individual rating analysis to key metrics about that company, and benchmark data to weighted values and produce an indicative rating. This is then reviewed internally to produce a final rating.

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Analysis

Key metrics

Benchmark and rate

Weigh

Indicative Rating

Other qualitative factors

Final rating


Importance of Credit Ratings

Credit ratings establish a link between risk and return. They thus provide a yardstick against which to measure the risk inherent in any instrument.

An investor uses the ratings to assess the risk level and compares the offered rate of return with his expected rate of return (for the particular level of risk) to optimize his risk-return trade-off.

The risk perception of a common investor, in the absence of a credit rating system, largely depends on his familiarity with the names of company and what they might know about the company.

It is not feasible for the corporate issuer of a debt instrument to offer every prospective investor the opportunity to undertake a detailed risk evaluation.

For the typical investor, it would difficult to assess all of the financial information available to assign their own risk ratings.

Thus the need for credit rating in today’s world cannot be over emphasized.


Module 2 Moody's, Standard & Poor's,

Fitch Ratings

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Nationally Recognized Statistical Rating Organization

In 1975, the U.S. Securities Exchange Commissionestablished the ‘Nationally Recognized Statistical Rating Organization’ (NRSRO) designation

Three of best known rating agencies in the U.S. were named:• Moody’s Investor Services• Standard and Poor’s• Fitch Rating

In 2003, the SEC approved a fourth NRSRO, Dominion Bond Rating Services (DBRS) from Canada.


Major Credit Rating Agencies

The major agencies were either independent or owned by nonfinancial companies.

Moody's, a subsidiary of Dun and Bradstreet, dominated the market for commercial credit ratings.

Standard and Poor's was a subsidiary of McGraw-Hill, a major publishing companywith a strong business information focus.

Fitch, initially a publishing company, was bought by an independent investor group in 1989.

Credit-rating agencies are often regarded as the gatekeepers of the capital markets

because of the impact of their opinions on the structuring and pricing of financial products.


Rating Scales used by Major Credit Raters

The three largest credit rating agencies each use different scales for their ratings as shown here:


Value of Credit Ratings

Credit ratings can also speak to the credit quality of an individual debt issue, such as a corporate note, a municipal bond or a mortgage-backed security, and the relative likelihood that the issue may default.

The credit rating represents the credit rating agency's evaluation of qualitative and quantitative information for a company or government; including non-public information obtained by the credit rating agencies analysts.

Each agency applies its own methodology in measuring creditworthiness and uses a specific rating scale to publish its ratings opinions.

A poor credit rating indicates a credit rating agency's opinion that the company or government has a high risk of defaulting, based on the agency's analysis of the entity's history and analysis of long term economic prospects


Factors Involved in Credit Rating

Credit rating depends on several factors, some of which are tangible/numerical and some of which are judgmental and intangible. These factors include: Overall fundamentals and earnings capacity of the

company and volatility of the same. Overall macro economic and business/

industry environment. Liquidity position of the company (as distinguished

from profits). Requirement of funds to meet irrevocable commitments. Financial flexibility of the company to raise funds from

outside sources to meet temporary financial needs. Guarantee/support from financially strong external bodies. Level of existing leverage (borrowings) and financial risk.

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S&P Credit Rating Process

This is an example of a rating process:

1. The issuer of a financial product requests a rating

2. The rating agency does an initial evaluation

3. This may include meetings with an issuer’s management team

4. The financial product is reviewed5. The analysis is reviewed by a

rating committee6. Once a rating is assigned the

issuer is notified7. Ratings are then distributed to

the public 8. Rating agencies then monitor the

issuers and reports adjustments.

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Rating data flow…

DATABASE

Rating Methodologies Adjustment Worksheets

Company Reports

XYZ Company

Adjusted Financial Statement Data


Nature of Credit Rating

Rating is based on information: A rating is not based entirely on published information and the success of a rating agency depends, on its ability to access privileged information. Cooperation from the issuers as well as their willingness to share even confidential information are

important pre-requisites. The rating agency must keep information of confidential nature possessed during the rating process, a

secret.

Many factors affect rating: A rating is given by taking into account the quality of management, corporate strategy, economic outlook and international environment. To ensure consistency and reliability a number of qualified professionals are involved in the rating

process. The Rating Committee, which assigns the final rating, consists of specialized financial and credit analysts. Rating agencies also ensure that the rating process is free from any possible clash of interest.

Rating by more than one agency: In a well developed capital market, debt issues are often rated by more than one agency. And it is only natural that ratings given by two or more agencies differ from each other e.g., a debt issue,

may be rated ‘AA+’ by one agency and ‘AA’ or ‘AA-’ by another. It would be unusual if one agency assigns a rating of AA while another gives a ‘BBB’.


Module 3Rating Methodology

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Rating Methodology The methodology for creating a rating involves an analysis of all the factors

affecting the creditworthiness of an issuer company: business, financial and industry characteristics, operational efficiency, management quality, competitive position of the issuer and commitment to new projects etc.

• A detailed analysis of the past financial statements is made to assess the performance and to estimate the future earnings.

• The company’s ability to service the debt obligations over the tenure of the instrument being rated is also evaluated.

• In fact, it is the relative comfort level of the issuer to service obligations that determine the rating.

A rating analysis includes the following factors: 1. Business Risk Analysis2. Financial Analysis3. Management Evaluation4. Geographical Analysis5. Regulatory and Competitive Environment 6. Fundamental Analysis


Business Risk Analysis Business risk analysis aims at analyzing the industry risk, market position of the company, operating efficiency and legal position of the company.

Industry risk: The rating agencies evaluates the industry risk by taking into consideration various factors like strength of the industry prospect, nature and basis of competition, demand and supply position, structure of industry, pattern of business cycle etc.

Industries compete with each other on the basis of price, product quality, distribution capabilities etc.

Industries with stable growth in demand and flexibility in the timing of capital outlays are in a stronger position and therefore enjoy better credit rating.

Market position of the company: Rating agencies evaluate the market standing of a company taking into account:

i. Percentage of market share ii. Marketing infrastructureiii. Competitive advantages iv. Selling and distribution channelv. Diversity of products vi. Customers basevii. Research and development projects viii. Quality Improvement programs undertaken to identify obsolete products


Business Risk Analysis - continued Operating efficiency: Favorable locational advantages, management and labor

relationships, cost structure, availability of raw-material, labor, compliance to pollution control programs, level of capital employed and technological advantages etc. affect the operating efficiency of every issuer company and hence the credit rating.

Legal position: Legal position of a debt instrument is assessed by letter of offer containing terms of issue, trustees and their responsibilities, mode of payment of interest and principal in time, provision for protection against fraud etc.

Size of business: The size of business of a company is a relevant factor in the rating decision.

Smaller companies are more prone to risk due to business cycle changes as compared to larger companies.

Smaller companies operations are limited in terms of product, geographical area and number of customers.

Whereas large companies enjoy the benefits of diversification owing to wide range of products, customers spread over larger geographical area.

Business analysis covers all the important factors related to the business operations over an issuer company under credit assessment.


Rating Methodology Financial Analysis: Financial analysis is used to determine the financial strength of the

issuer company through quantitative means such as: ratio analysis cash flow analysis study of the existing capital structure.

Both past and current performance is evaluated to comment the future performance of a company This includes an analysis of four important factors namely: Accounting quality: As credit rating agencies rely on the audited financial statements,

the analysis of statements begins with the study of accounting quality. This includes: qualification of auditors, overstatement/understatement of profits, methods

adopted for recognizing income, valuation of stock and charging depreciation on fixed assets are studied.

Earnings potential/profitability: Profits indicate company’s ability to meet its fixed interest obligation in time.

A business with stable earnings can withstand any adverse conditions and also generate capital resources internally.

Profitability ratios like operating profit and net profit ratios to sales are calculated and compared with last 5 years figures or compared with the similar other companies carrying on same business.

As a rating is a forward-looking exercise, more emphasis is laid on the future rather than the past earning capacity of the issuer.


Cash Flow and Financial Analysis Cash flow analysis: Cash flow analysis is undertaken in relation to debt and

fixed and working capital requirements of the company. Indicates the usage of cash for different purposes and the extent of cash available for

meeting fixed interest obligations. Cash flows analysis facilitates credit rating of a company as it better indicates the

issuer’s debt servicing capability compared to reported earnings. Financial flexibility: Existing Capital structure of a company is studied to find:

The debt/equity ratio, alternative means of financing used to raise funds, ability to raise funds, asset deployment potential etc.

The future debt claims on the issuer’s as well as the issuer’s ability to raise capital is determined in order to find issuer’s financial flexibility.

Management Evaluation: Any company’s performance is significantly affected by:

Management goals, plans and strategies Capacity to overcome unfavorable conditions staff’s own experience and skills, planning and control system etc.

Rating of a debt instrument requires evaluation of the management strengths and weaknesses.


Additional Analysis

Geographical Analysis: Geographical analysis is undertaken to determine the locational advantages enjoyed by the issuer company. An issuer company having its business spread over large geographical area

enjoys the benefits of diversification and hence gets better credit rating. A company located in backward area may enjoy subsidies from government

thus enjoying the benefit of lower cost of operation. Thus geographical analysis is undertaken to determine the locational

advantages enjoyed by the issuer company. Regulatory and Competitive Environment: Credit rating agencies evaluate

structure and regulatory framework of the financial system in which it works. While assigning the rating symbols, CRAs evaluate the impact of

regulation/deregulation on the issuer company. Fundamental Analysis: Fundamental analysis includes an analysis of

liquidity management, profitability and financial position, interest and tax rates sensitivity of the company.

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Rating scale

Aaa

Aa(1-3)

A(1–3)

Baa(1-3)

Ba(1-3)

B(1-3)

Caa(1-3)

Ca

C

Minimal credit risk

In default,little prospect of recovery

InvestmentGrade

HighYield

Watch list =under review

Outlook =likely direction


Rating Categories Ratings are constructed to represent the risk of default;

that is, a high (low) rating implies a low (high) probability of default. Default refers to any event that results in the issuer’s

breaching its financial contract. Large companies with strong and stable cash flows are likely to

be rated higher than small companies with more volatile cash flows.

Investment grade refers to the safest levels of financial securities. Investment-grade securities have historically exhibited

relatively low rates of default. Speculative grade, or noninvestment grade, refers to the

riskier securities. Debt rated BB (Ba for Moody’s) or below is noninvestment

grade, and is sometimes referred to as “high yield” or “junk.” Default rates among these classes of securities are

comparatively high. Within the major rating categories (AA, A, etc.), credit

ratings are often modified to show relative standing within a category.

Moody’s uses numbers 1, 2, and 3, while S&P and Fitch use plus (+) and minus (−) signs.


Nature of Credit Rating Monitoring the already rated issues: Rating agencies monitor all outstanding debt

issues rated by them as part of their investor service. Rating agencies may put issues under a credit watch and upgrade or downgrade the ratings as per the circumstances after intensive interaction with the issuers.

Publication of ratings: Once a rating is accepted it is published and subsequent changes emerging out of the monitoring by the agency will be published even if such changes are not found acceptable by the issuers.

Right of Appeal: Where an issuer is not satisfied with the rating assigned, a review may be requested. Unless the rating agency had over looked critical information at the first stage chances of the rating being changed on appeal are rare.

Rating is for instrument and not the issuer company: A rating is done for a particular issue and not for a company or the Issuer. It is quite possible that two instruments issued by the same company carry different

ratings, if maturities are substantially different or one of the instruments is backed by additional credit reinforcements like guarantees.

In many cases, short-term obligations, like commercial paper (CP) carry the highest rating even as the risk profile changes for longer maturities.


Nature of Credit Rating Rating not applicable to equity shares: A credit rating is an opinion on the issuers

capacity to service debt. For equity shares there is no debt servicing obligation, so credit rating does not apply to equity shares.

Credit vs. financial analysis: Credit rating is much broader concept than financial analysis. One important factor which needs consideration is that the rating is normally done at the request of and with the active co-operation of the issuer. The rating agency has access to unpublished information and the discussions with the senior

management of issuers give meaningful insights into corporate plans and strategies. Necessary adjustments are made to the published accounts for the purpose of analysis. Rating is

carried out by specialized professionals who are highly qualified and experienced. The final rating is assigned keeping in view the number of factors.

Time taken in rating process: The rating process is a fairly detailed exercise. It involves analysis of published financial information, visits to the issuers offices and

works, intensive discussion with the senior executives of issuers, auditors, bankers, and creditors etc.

All this takes time, a rating agency may take 6 to 8 weeks or more to arrive at a decision.


Module 4Advantages and Disadvantages

of Ratings

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Benefits of Ratings

For Companies Market access (gate keeping) Expands breadth of market Widens distribution Improves liquidity Improves pricing Helps management with

independent, outside perspective on company

Helps management monitor counterparty risk

For Investors Due diligence efficiency Multiple independent perspectives Facilitates comparisons Tool in portfolio management Enhances secondary market liquidity Relatively stable over time Basis for performance benchmarks

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Advantages of Credit Rating

Benefits to Investors Safety of investments. Recognition of risk and

returns. Freedom of investment

decisions. Wider choice of investments Dependable credibility of

issuer Easy understanding of

investment proposals

Benefits the Company Easier to raise funding Reduced cost of borrowing Reduce cost of public issues Ratings can build up image Ratings facilitates growth Recognition to unknown

companies

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Benefits to IntermediariesFor brokers ratings make it easier to persuade clients to select an investment proposal of investment in highly rated instruments.


Disadvantages of Credit Rating

Credit rating suffers from the following limitations: Non-disclosure of significant information Static study Rating is no certificate of soundness Rating may be biased Rating under unfavorable conditions Difference in rating grades Improper Disclosure May Happen Impact of Changing Environment Problems for New Companies Downgrading by Rating Agency


Questions


Thank You !


About the Author/Presenter

Floyd Saunders has worked on Wall Street with both Bank of America and JPMorgan, where is was a vice president in global financial systems. He has worked across the industry in retail, commercial, and investment banking.

He has taught courses in Money and Banking and extensively for the American Institute of Banking and various colleges.

As a consultant, he developed and taught a wide range of banking and investing courses.

He authored three programs for the American Bankers Association: Banking on Mutual Funds and Annuities, Introduction to Securities Markets and Investing in Securities.

He is the author of “Figuring Out Wall Street” and his next book is “Family Financial Freedom” a book on personal money management.


Reference Material

Book summary: Figuring Out Wall Street, is the concise guide to help everyone understand how what to do now to restore our financial systems. Written in an easy to understand manner, even the most complex financial concepts are easy to digest. This book provides help to monitor investments with a review of investment products, financial regulators and economic indicators. Learn how the stock market exchanges work and the world of investment banking, hedge funds, venture capital and private equity. Every chapter includes action plans for investing.

Figuring Out Wall Street Consumer’s Guide To Financial Markets By Floyd Saunders Publisher: Saunders Learning Group

ISBN: 978-0-9824019-0-3

Available from Amazon: http://www.amazon.com/Figuring-Out-Wall-Street-Consumers/dp/0982401906and many other online book stores.

Intro to Credit Rating Agencies

Economy & Finance

Transcript of Intro to Credit Rating Agencies