Highlighting Credit Risk

Anjan Ghosh | Print Edition: December 2011

Credit ratings aim to enhance transparency in debt markets by providing an independent opinion of credit risk, thus reducing the information asymmetry between borrowers and lenders. It enhances investor confidence and allows borrowers to market their debt securities.

A rating is an agency's opinion on the capability of a corporate entity to service their debt obligations. A rating is based on an objective analysis of the information and clarifications obtained from the lender, as also from other sources considered reliable by rating agencies. All relevant factors that have a bearing on the future cash generation of the issuer is considered.

These factors include: industry characteristics, the competitive position of the issuer, operational efficiency, management quality, commitment to new projects and other associate companies and funding policies of the issuer.

Due weightage is also given to the issuer company's management strengths and weaknesses from a corporate governance perspective. A detailed analysis of financial statements is made to assess the company's financial strength.

Estimates of future earnings under various scenarios are drawn up and evaluated against their obligations over the tenure of the instrument being rated. Primarily, it is the relative comfort level of the issuer's cash flow to service debt obligations that determines a rating.

Credit ratings are not investment recommendations as an investment decision should be based on factors apart from credit risks, such as liquidity in the market and interest rate fluctuations.

A higher rating signifies lower credit risk or a higher degree of safety regarding payment of interest and principal. In general, a higher rated company would offer a lower rate of interest, though there could be variations depending on other factors-such as tenure of debt and market conditions.

Credit ratings can also be revised if there has been a significant change in the business or financial risk profile of the issuer. If the debt markets are liquid, an investor can exit from an instrument if the rating falls below a level that he is not comfortable with while an investor looking for higher returns, and therefore willing to take a higher risk, can invest in such an instrument.

Credit ratings are not investment recommendations since the investment decision should also be based on factors apart from the underlying credit risks. A rating is only an additional input. Also, an investor in a debt instrument is also exposed to risks such as liquidity in the market and interest rate fluctuations, which ratings do not address.

The secondary debt market in India is currently limited. However, an active debt market, particularly in long-term private debt instruments, is essential to realise the benefits of economic reforms in the country.

The presence of small investors is critical to this process and therefore ratings will have an increasingly important role in highlighting the credit risks associated with instruments designed for retail investors.

Group Head-Corporate Sector Ratings, Icra Limited

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