How credit rating agencies work

You may be looking to invest in fixed deposits or bonds with the highest interest rates, but do you know how safe they are?

Given the many investment options available, you should look to minimise risk while pursuing high returns. This is where rating agencies such as CRISIL, CARE and ICRA come to your rescue. They assess the credit and default risk on these products and tell you how safe they are.

Investment grade ratings

The rating scale for deposits and bonds range from ‘very high safety’ denoted by the symbol AAA to potential ‘default’ grade which is represented by a D symbol. According to the global rating agency Standard & Poor’s, any bond with a rating below BBB (which denotes moderate safety) is considered to be non-investment grade, practically a ‘junk’ rating. However, there may be minor variations in rating symbols between agencies.

CRISIL and ICRA rated instruments with ratings lower than an A grade are below investment grade. The adjoining table details the rating symbol for FDs and NCDs (Non-convertible Debentures) used by these agencies.

In addition to rating, rating agencies also provide an outlook on the rating. Rating outlook indicates the likely direction of change in the company’s rating. For instance, a fixed deposit with BBB rating and a negative outlook may mean a higher probability of downgrade to a BB grade. This can be as risky as a BB rated deposit, implies moderate default risk. Hence, it is important to understand the rating outlook on the instrument you intend to invest in. It is prudent to avoid instruments below an A grade rating, considering the safety of the interest and principal invested.

How they rate

Knowing the methodology will help you appreciate these ratings better. Rating agencies analyse the various risks associated with a business while rating deposits and bonds.

Some risks may be inherent to the industry the company operates in. For instance, while evaluating a commercial vehicle NBFC, rating agencies analyse the level of economic activity and trend in freight rates. But even amid an adverse industry trend, there may be companies with a strong footing and sound fundamentals. Hence, rating agencies look at company specific parameters to assess the relative standing of the company within an industry too.

For instance, while assessing a car loan company, a rating agency may look into the credit profile of the promoter, share holding pattern and promoter’s track record. . These can influence the company’s profitability and ability to mobilise funds. Parentage matters too, as companies backed by a strong parent may even tide over the most difficult times. Rating agencies also consider aspects such as size of the franchise and capability to grow in their market in deciding on a rating.

The parameters used to measure risks also vary with the industry. For instance, while evaluating a company which manufactures fertiliser, the distribution and pricing of which is controlled by government, these agencies look into the risks associated with any adverse policy move by the government. Given the dependence on the government for subsidy, companies better placed to withstand delayed subsidy payments and those which have diversified into non-subsidy businesses will be viewed favourably.

>nalinakanthi.v@thehindu.co.in

COMMENT NOW