Credit Ratings : All You Want To Know

Author : Deependra Shekhawat

Credit Rating refers to a rating assigned by a Credit Rating Agency to an entity or to a government (country) in respect its issued debt securities like bonds, debentures etc. When credit rating is assigned to a government/country then it is called "Sovereign Credit Rating". Credit rating denotes the ability and willingness of an entity or a government to honor its debt obligations i.e. Interest and Principal. Moody’s, Standard & Poors and Fitch  are the credit rating giants in the world, collectively known as "Big Three" holding almost 95% of global credit rating business. 

It is pertinent to note the nature of rating given, a credit rating is only an opinion expressed by a credit rating agency on the credit worthiness of an entity or a government, involving no recommendation to park his money to the entity or debts so rated.

 There are in general, two types of credit ratings namely, Short term credit rating and Long term credit rating.  Former for securities having maturities upto 12months, later being for residuary terms of maturities.

 Further, Short Term and Long Term Credit Ratings are divided into four categories namely;

(i) High Credit Rating : - A high credit rating for example AAA/Aaa/AA/Aa/A for an entity or a government signifies that, the said entity or the government is the Best Investment Option for the potential investors and the funds invested may well be assumed in safe hands with Lowest Risk to the investors.

(ii) Low Credit Rating - A low credit rating for example BBB/Baa/Ba/BB  for an entity or a government signifies that, the said company or the government may be a Moderate option for the investors to invest their money. Money invested in such entities or governments (Countries) may still be assumed in safe hands with Low Risk to the investors.

(iii) Junk Rating - Junk rating is further divided into two parts. However, their nomenclature is not practically used as such and are broadly identified with the term Junk, assigned here for better understanding only.

(a) Junk Speculative :- Such kind of rating may be denoted by CCC/Ca/CC/C for an entity or a government. An entity or government with such a rating is viewed as a Speculative Investment Option with Highest Risk to the investors.

(b) Junk "In Default" :- Such kind of rating may be denoted by DDD/DD/D for an entity or a government whose payments of debt obligations are in Default. Such a company is generally unable to attract the investors even on higher interest payouts.

(iv) Recovery Rating - A recovery rating is a sub opinion included in "Credit Rating Opinion". Recovery rating is the percentage of potential recovery which an investor can expect to        recover from the issuer of security against his outstanding/unpaid balance in the event of default. A recovery rating may be denoted in numbers like 3,2,1 & 0  where 3 may denote 100% recovery, 2 may denote 80 to 100% recovery 1 may denote 50 to 80% recovery and 0 may denote 0 to 50% recovery say if recovery rating for X Enterprise is 1 then it suggests that a person investing euro 10,000 in 16% debt securities of X Enterprises can expect a maximum refund of euro 5,000 to 8,000 as principal and euro 800 to 1,280 p.a as interest in the event of occurrence of default on part of X Enterprises. However, some of the agencies do include such opinion in their main opinion. Whenever, such a recovery rating is issued to an entity then it is expressed in the main opinion and not as part of a separate opinion. Such a rating is important for an investor evaluating "Non Investment Grade Securities". (Discussed later in this article).

 Sovereign Credit Rating :- When the credit rating is assigned to a government/country then it is called "Sovereign Credit Rating". A Sovereign credit rating signifies the ability and willingness of a government to honor its debt obligations as well as ability of a government to provide a secure investment environment to the potential investors. Such credit rating is a reflection of factors like economic status of a country, political stability, transparency in the capital market, level of public and private investment flows, Foreign Direct Investment (FDI), Foreign Currency Reserve (FCR), ability of an economy to remain stable despite a government change, etc.

It is important to encompass one more dimension of these ratings. Ability and willingness to service periodic payments may be assessed in respect of not only domestic but also foreign currency as well. An entity or a government may be highly rated as regards it ability and willingness to honor its debt obligation in domestic currency while the same entity or government may be low rated/Junk rated when it comes to honor its debt obligation in foreign currency.

 Based on credit ratings, securities are classified into two categories namely;

 (i) Investment Grade Securities: Securities of companies having high credit ratings like AAA are treated as "Investment grade securities.

 (ii) Non Investment Grade Securities/Speculative Grade Securities:  Securities of companies which currently are capable of meeting their debt obligation but are facing future       uncertainties regarding their debt obligations are classified as Non Grade Investment Securities. Entities with credit rating BBB/CCC/DDD may fall under this category based on future uncertainties involved.

What is the significance of high, low and junk Credit Rating for the issuing entity?

Entity or government with high credit rating can seek further debts/loans etc. at comparatively lower interest rates, hence easing availability of funds. Conversely, an entity or a government with low rating has to raise further debts/loans etc. at high interest rates. An entity or a government with junk rating is no longer an appropriate investment alternative.

The Bottom Line- Higher the rating lower is the "Borrowing Costs" or vice versa.

Review of Credit Rating : Once assigned, a credit rating is not the final one and needs to be reviewed every year. Accordingly a credit rating previously issued may be upgraded (i.e. improved) or downgraded (i.e. battered) as per the latest financials of the issuer of security. For eg. Moody's downgraded Sony's rating from B1 to B3 for the FY 2013 - 2014 and it (Moody's) opined that, Sony had to do a lot with its "Battered Balance Sheet" of FY 2012 - 2013 but they failed to improve their Balance Sheet and therefore, we (Moody’s) have no choice except to downgrade their rating to junk level. The rating agencies are required to publish the revised ratings on their websites.

Independence of Credit Rating Agencies has also attracted lot of negative response. A section of intelligentsia blames credit rating agencies for global crisis of 2008, for they assigned high credit rating to entities which ended up being bankrupt subsequently.

The Judgment given by Federal Court of Australia finding the rating as "false" or "negligent misrepresentation”, resulted in 4% and 3%  decline in share price of Standards & Poors and Moody's respectively in New York Trading. However, it should be noted that, credit rating agencies may be held liable for "Inaccurate Ratings" and not for their "Expression of Opinion.

Exchange Traded Funds : Meaning & Benefits

With government clearing Central Public Sector Enterprises -Exchange Traded Fund (CPSE-ETF or simply PSU-ETF), they will soon be traded in the bourses. Before discussing the merits and success-factors of PSU-ETF, it will be good to know what an Exchange Traded Fund(ETF) is.

Started in 2001, there are presently 33 ETFs, like other instruments ETF is an investment fund which tracks a certain index. They are traded on stock exchanges similar to shares. An ETF holds assets like stocks, bonds, etc of which it track prices.

ETFs are different from Mutual Funds (MFs) although they both have the feature of representing the value of investments backed, in their own prices. Firstly, ETFs are traded like stocks unlike MFs where one gets value as per the Net Asset Value (NAV) of the fund. So in MFs while one buys/sells Units, in case of ETF one actually buys/sells shares of the portfolio of the ETF which explains the changes in the price of ETF throughout the day in stock exchange. Secondly, the asset manager of MF try to generate returns for the unit holders by beating the index (say by investing in non-index shares), while ETF always goes in consonance to the prices of the stock of its portfolio, hence as said ETFs don't try to beat the market they try to be the market. Gold-ETFs dominate Indian ETFs.

Few benefits of ETFs over MFs which puts them in promising position in future are:

• They allow real time buying and selling of shares.
• Lower expense ratio, since ETFs need not to invest in liquid assets like MFs.(for redemption of units.)
• Tax Efficiency.

CPSE-ETF

This will comprise of shares of 11 blue chip PSU companies like ONGC, CIL, Power Grid, etc.

It’s worth noting that this is government's way of monetizing its assets. Facing protest in direct disinvestment of PSUs coupled with difficulty to achieve disinvestment target of Rs. 40,000 crore this fiscal due to cold market response, this is an alternative to direct share sale. CPSE-ETF is supposed to raise Rs. 3,000 crore to the govt. exchequer. However there are certain determinants which will decide the way CPSE-ETF will be received, major ones are:

• The discount at which they will be offered. Apparently in the past Indian market to ETFs has been quite moved solely by the rate of discount which is offered compared to other factors.
• Most importantly, the way insurers will receive this ETF will have a large hand in determining the success of it. However in my view, the scheme of CPSE-ETF, finds itself inconsistent with the present draft rules made by IRDA for the same. Say for example the maximum expense ratio prescribed by IRDA rules which will be flouted as per present scheme of expenses of CPSE-ETF, thereby setting the insurers aside.

Resolution of these inconsistencies will pave the way for better reception of the issue.  

Penalty on Coal India Ltd. by CCI : Reasons and Implications

The Competition Commission of India has imposed a penalty of Rs.1773.05 crore on Coal India Limited and its three subsidiaries for abusing their dominant position as supplier of coal to power companies. CCI held that CIL through its subsidiaries is operating independent of market forces and enjoys undisputed dominance in production and supply of non-coking coal in India. Apart from cease and desist orders, it also directed CIL to Modify FSAs suitably.

The Order came post complaint filed by Maharasthra State Power Generation Co. Ltd and Gujrat State Electricity Corporation Ltd. They alleged low quality coal dispatches at high prices and non transparency in contract conditions.The lopsidedness of FSAs have been a bone of contention between CIL and Power Producers in the past.However the fact that these FSAs have been foisted upon CIL without completely considering the ground realities is being absolutely overlooked in the order.

Clauses of FSAs in particular were directed to be modified related to sampling and testing procedure, charging transportation and other expenses for supply of ungraded coal from the buyers, capping compensation for supply of stones.

The clause for sampling and testing relates to quality of coal. Price charged for ungraded coal is also challenged.Notably as per provisions of FSAs in 2009, Coal India is charging Rs. 1 per tonne for such ungraded coal, which seems in my view good in accounting practice as there need to be a minimum billing and for ensuring other control aspects of movement of coal.As far as capping compensation for supply of stones is concerned, at present as per FSA compensation is given within 2 months of the date when notice for such stone being dispatched is brought to notice of the company, obviously after following check. The compensation has been capped at .75 pc for companies which sources coal from companies other than Coal India too. The Present practice of compensation is being followed in respect of other companies.

CIL appealed against the order before the Competition Appellate Tribunal which ordered to maintain status quo until further orders. However this is just a stay and the liability for penalty is still alive. There may be more penalties in way as CCI has also received more complaints .

In case of unfavourable decision for CIL in future, it has the option of approaching Supreme Court. 

However the case holds wider implications which are

• This is the first time CCI has moved against Public Sector entity and imposed a penalty. Thereby signalling its neutral stand over both sectors. CCI explicity expressed that they are aware of the regulated environment in which CIL operates, hence playing down the observation being made by CIL Board that CIL doesn't enjoy commercial freedom.
• We can expect the indifferent attitude of Government as the penalty will help in the objective of fiscal correction.Its worth mentioning that in India any penalty imposed by independent regulator goes to Consolidated Fund of India.
• The amount will not be allowed as Business expenditure under Income Tax Law hence adding tax burden. To put it differently the gainer in case of penalty being imposed will be only government. It will get Income Tax, Penalty amount and also will not have to share anything with the shareholders..!! (In other case it would have got Dividend distribution tax and sizable dividend.)  
  
  

Islamic Banking : All You Need To Know

The purpose of this article is to highlight what is Islamic Banking,its need and accompanying challenges. Islamic Banking is a subset of a broader concept of Islamic Finance which include Islamic insurance (aka Takaful) apart from Islamic banking. Islamic Finance is Sharia law based system of finance, which in turn finds its source of standards and law in Holy Koran and Hadeeth(sayings of Prophet Mohammad).

Islamic Banking operates on basic principles like

• It prohibits any receipt or payment of Interest (Riba)and considers it as 'haraam', however it promotes profit (loss) sharing.
• It prohibits application of money for alcohol,tobacco,pork processing,speculation,betting,etc.
• It prohibits trading in Debt, hence Islamic banking compliant banks issue Sukak or Islamic Bonds which are in spirit to the Sharia law.

Ways in which Islamic Banking is done are:

• Mudarabah, a profit-sharing agreement.
• Wadiah, a safe keeping arrangement.
• Musharakah, or a joint venture for a specific business. 
• Murabahah, cost plus arrangement where goods are sold with a pre-determined margin of profit
• Ijirah, a leasing arrangement.

The reason for disallowing interest earning is based on the principle of 'No Money without Risk taking' if done so it is considered to be exploitative.Furthermore the law promotes entrepreneurship.

Very natural question is why we need it? The answer lies in its potential for acting as an alternate to conventional banking system and by acting as an agent of financial inclusion and overall growth of the banking industry.Post global financial crisis the importance of Islamic banking has been realized, for the reason it is devoid of interest factor which is the central point of present system hence insulating itself from risks associated.West Asia, Malaysia, Indonesia,etc. are the countries where the system of Islamic banking is gaining currency.Notably, the assets of Islamic Banks have risen at an average rate of 15% over the last decade.It may act as an all acceptable measure of innovative and inclusive growth. Islamic Banking is not for muslims alone,in countries like U.K., Malaysia more than 40% of the customers of these banks are non-muslims.

For India, Islamic Banking holds vast array of promises, firstly it will increase investment by muslims in particular, finding the system in sync with their religious belief and by others in general.Further flow of money from Indian diaspora settled outside especially West Asia will increase,Sukuk may be used for infrastructure financing.Above all it will augment the entrepreneurial spirit in the country.

However several challenges need to be given heed to. There is serious conflict in banking laws in force in our country and Islamic banking principles.Present law mandates compulsory payment of interest on deposits and prohibits any sort of trading unrelated to the business of banking which are pillars of Islamic Banking. Ex- RBI Governor also stated incongruity in present laws to accommodate sharia based banking. Procurement of Funds for operations require mass awareness and participation. Utilization of funds for specified purposes entails closer supervision along with commensurate infrastructure and competent personnel. We need to move to Islamic Banks from just allowing NBFCs to operate that way.It will certainly help attaining national objective of financial inclusion.