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Want to Minimize Your Risk - Go with Credit Rating

    Mr. Shyam | Saturday, December 19,2009, 08:21 PM
 

hinking to invest in Market…..??? Moreover you are a risk-averse investor and want to minimize your risk….??? There is an investment avenue for you that are bonds and debt instruments which can give you fixed returns. They yield more returns as compared to the fixed deposits and the national saving certificates. But the question is…, as an investor how do I get the information as to which are the good ones amongst them. The answer would be to go as per the Credit rating given to the securities.

After all What is credit rating…? What is its importance…?? and What does that Indicate…???

There are thousands of companies in India all of them require capital for functioning and they issue securities to get funds.

Purpose of Credit Rating

Credit rating agency is set up in order to protect the interest of the small or retail investors who invest in debt securities of companies. India was the first nation amongst developing nations who started this.

In India, CRISIL (Credit Rating and Information Services of India Ltd.) was setup in 1987 as the first rating agency followed by ICRA Ltd. (formerly known as Investment Information & Credit Rating Agency of India Ltd.) in 1991, and CARE (Credit Analysis and Research Ltd.) in 1994. All the three agencies have been promoted by the All-India Financial Institutions. The rating agencies have established their creditability through their independence, professionalism, continuous research, consistent efforts and confidentiality of information.

Credit ratings are given by different organizations after considering many parameters. A word of caution to investors is that whatever may be the rating given to the securities it does not indicate whether investor should hold or sell and the process followed has many steps which many of the experts have agreed with so the credit ratings become highly subjective if your way of measuring is different, nevertheless this is one of the way to know about safety of your investment. The company and the issuer of credit rating agency are not related it is just for the time that agency has rated the securities of a company and it is up to the company whether to accept or reject the ratings. However these ratings are what is largely followed by investors.

What do the ratings indicate…?

The type and nature of security that is being offered

Timely payment of principal and interest

The probability of the issuer defaulting

Companies approach credit rating agencies in order to get their debt securities rated. Now it is up to company whether to accept the rating and in case it is not happy with the rating it is not obliged to reveal it to public and it may approach another agency, but it has been seen that though it is rated by different agencies rating may not vary to a great extent that one agency awards it with AAA+ and another agency BBB.

Major Credit Rating agencies in India

In India there are 4 major agencies they are;

CRISIL promoted by ICICI

ICRA promoted by IFCI

CARE promoted by IDBI

Among these agencies CRISIL & ICRA combined have a larger market share.

Factors involved in Credit Rating

  • Business risk analysis which involves industry analysis, market share, competitors, marketing infrastructure, competitive advantages, selling and distribution channel, customer base, research and development, operating efficiency, legal position etc.
  • Financial analysis which include accounting principles, accounting quality, earning potentiality or profitability, cash flow analysis, financial flexibilities etc.
  • Management evaluation involving mission and vision and steps being taken to improve the quality of management, plans and strategies, skills of employees etc.
  • Geographical analysis which finds out competitive advantages followed by companies just by the geographical location, whether the company is diversified and global presence.
  • Fundamental analysis

What do the ratings indicate?

Rating agencies have different codes for giving their opinion about debt securities issued by companies. The way rating is done and the codes given by agencies are same. Ratings of securities as given by CRISIL in decreasing order of quality are AAA, AA+, AA, AA-, A+, A, A-, BBB-, BBB, BBB+, BB+, BB, BB-,B+, B, B-, C and D. ICRA, CARE and Duff and Phelps have similar grading systems.

Some of the grades and what they mean are

  • AAA
  • AA
  • A
  • B
  • C
  • D

AAA - Highest safety - These companies are fundamentally strong and these offer highest safety and guaranteed returns. The principal and interests are done on time.

AA - High safety- These offer high safety and timely returns of principal and interest but the safety assured is low compared to that is provided by triple A

A - Adequate safety- These offer adequate safety about interest and principal returns but changes in circumstances have an affect on these debt instruments.

B - High Risk- Debt securities having this rating are more susceptible to default. The adverse economic conditions can have a greater impact on these companies and hence affect the liability.

C - Substantial Risk- these debt instruments are said to be have certain factors on effect of which these instruments are vulnerable to default. There is a high risk involve.

D - In Default- these are highly speculative instruments and high risk is involved in investing these securities.

As we come down lower the order risk increases and so is the case with returns, because the golden rule of market “higher the risk, higher are the returns” is applicable in this case too.

Advantages of Credit Rating

  • Investors need not seek help of experts in this matter as ratings speak for themselves so in a way it reduces pressure which is on investors.
  • It attracts investors and helps in maintaining the stability of financial market.
  • It helps investor to reduce his risk to a greater extent, if the investor follows ratings it means that he has analyzed financial conditions of company and is confident enough that his money is in safe hands and his returns are fixed.
  • Investor can estimate his returns just by having a look at the rating of security because rating of each security is given by considering past performance and future projections.
  • An investor can find out different avenues for investment depending upon his risk bearing.
  • Investor can easily understand and make his decision based upon rating.
  • On the other side it helps company to raise capital required quite easily and at lower rates.

Limitations of Credit Rating

  • The rating that is awarded is only for that issue of securities and is concerned with other issues concerned with the company
  • Rating awarded is concerned only with security and it does not say anything about the company and their business.
  • Ratings are highly subjective and there are many agencies in India who are into this field so it is up to investors to follow ratings given by agencies of their choice.
  • These ratings may be useful just for the present time and as the economic conditions keep on changing value of the securities may go in other direction.
  • Ratings are given into consideration data of the company and future cash flows are estimated, the estimates can never be achieved exactly for example they may make huge or just the normal profits.
  • These ratings are not applicable for the equity shares which are issued by the same company because credit rating gives takes into account ability of a company to serve the debt obligations and in case of equity shares there is no fixed debt obligation.
  • Credit rating takes a fair amount of time and if the economic conditions are rapidly changing then the rating may not be of that importance.
  • Keeping ratings in mind you can’t compare two different companies.
  • Rating process takes into account all the past performances which may or may not imply how the company will be performing in coming years, because changes can be brought in the technology, management of company etc.

Credit ratings applications in other fields

There are different avenues where credit ratings are applied apart from the debt related securities, some of them are

  • Country rating
  • Rating of real estate builders and developers
  • Rating of chit funds
  • Rating of states
  • Rating of banks

ICRA and CRISIL are two most prominent and followed rating agencies and they are into rating of banks. They are rating banks based upon six characteristics like capital adequacy, asset quality, management evaluation, liquidity position, system and control in short its acronym is CAMELS.

Is credit rating the ultimate measure…??? The answer would be no because you never know how rapidly there will be changes in economic conditions and what would be their implications on this particular company. Just to say whether the company will be getting huge profits or is it going to incur heavy losses and go bankrupt. One more thing is we never know whether the company has disclosed all its information in the sense the confidential information with the credit rating agency. This is where the accountability of a company and credit rating agencies arise.

Mr. Shyam

IndianMoney.com Research Associate

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