Security Analysis and Portfolio Management - Assignment Example

? Security Analysis and Portfolio Management of the Table of Contents What do you mean by credit Rating? 3 Objectives and Benefits of Credit Rating 5 Major Credit Rating Agencies in the World 8 Moody’s 8 Standard & Poor’s 9 Fitch 10 Rating Symbols of various agencies for bonds and stocks 10 Fitch Group 11 Moody’s 12 Standard & Poor’s 13 Methodology used in assessing the credit rating 14 CAMEL Rating 16 Issues Related to Credit Rating 18 References 20 Bibliography 22 What do you mean by credit Rating? The history of credit rating can be traced back to the early 1840s, when the financial crisis of 1837 took place. The increasing levels of non-payment, after the economic crisis can be cited as one of the primary causes behind the establishment of credit rating system. It was originated in USA and the first credit rating agency was set up in New York. Credit rating can be defined as the way of evaluating the credit worth of a debtor. According to Moody’s a rating is an opinion on the future ability and legal obligation of the issuer to make timely payments of principal and interest on a specific fixed income security (Gurusamy, 2009, p.88-89). In general, the evaluation of the various securities is done by the credit rating agencies regarding the ability of the debtor to pay back the financial obligations and the probability of becoming a defaulter. In addition, credit rating is also used by the individuals and business ventures that purchase bonds which are issued by the government and companies in order to determine the possibility that company or the government will fulfill its bond obligations. The credit rating is based on the records of earlier repayment and borrowing. Apart from that, the credit rating is also done on the basis of the company’s availability of assets and liabilities. The credit rating reflects the assessment of quantitative and qualitative information of a business or the government by the credit rating agency. The evaluation is also done by considering non-public information, which is obtained by the credit rating agencies. A credit rating is simply a code that is used by the lenders in determining whether they will provide a line of credit or loan to a business. The credit rating of a venture is affected by several factors. Some of the factors are convenient and some are inconvenient. A poor credit rating of the companies or the government indicates that they have high chances of not fulfilling the obligations. A credit rating also highlights about the credit quality and credit risk. The desirable characteristics of a credit rating are as follows: - Specificity: - The rating is in accordance with or specific to the debt instrument. Relativity: - The rating is based on the willingness and the relative capability of the instrument issuer to service the obligations of the debt specific to the terms of the contract. Guidance: - The credit rating is aimed to provide guidance to the investors regarding the credit risk associated with an investment. Qualitative and Quantitative: - In order to determine the credit grade, both qualitative as well as quantitative factors are used. The judgment made is however qualitative in nature. Not a Recommendation: - The rating does not provide any kind of recommendations to hold, buy or sell the instruments. This is because of the fact that credit rating does not take into consideration factors such as personal risk preferences, market prices and other factors that may impact the investment decision. Broad Parameters: - The credit rating is based on some of the parameters of information provided by the issuer and information collected from other sources. No Guarantee: - The rating as provided by the agency does not provide any assurance for the accuracy and completeness of the information regarding the factors of rating. The increasing importance and stupendous growth of crediting rating system has been mainly due to the globalization of the credit market, moving trends towards the privatization, due to the withdrawal of government’s security nets, the continuous intensification of information technology, increasing confidence in the competency of the market mechanism, growing importance of money and capital markets and the increased securitization of lending and borrowing. Objectives and Benefits of Credit Rating The major objective of credit rating is to provide credit rating of the securities at a low cost to the investors. The rating is provided to the investors primarily to assist them in making decision about the risk return trade off. Apart from that, some of the other objectives of credit rating are as follows: - To improve the decision making process of the borrowers. To offer authentic information at a low cost. To offer greater credibility to the financial representations. To facilitate formulation of guidelines of institutional investment (Chapman, 2013). To help merchant bankers, regulatory authorities and brokers in discharging their issue pertaining to debt. To reduce the interest cost of the companies. However this objective is only valid for the companies having high credit rating. To act as a tool of marketing. Credit rating is a crucial factor for the borrowers in order to gain access to debts and loans. An individual or an entity with good credit ratings, finds it easy to borrow capital from the public debt market or financial institutions as it has high credit rating. For example, at the individual level, banks usually depend upon the credit rating of the individuals, in determining whether to sanction loan or not. Hence if the credit rating is found to be poor, the financial institutions may even reject the loan application. However, at the corporate level, the credit rating depends on the willingness of the company to select a credit rating company for rating their debt. Meanwhile, investors depend heavily on the company’s credit rating to buy bonds and stock. Apart from that some of the other benefits of having credit rating system are as follows: - Systematic Risk Evaluation: - In order to ensure competent and well organized allocation of resources, it is important to evaluate the risks systematically. Now, through the process of credit rating, a detailed and systematic evaluation of risk can be carried out. Moreover, credit rating also assists heterogeneous group of investors to reach at a consensus and meaningful conclusion. Information Service: - The credit rating system help the probable investors to identify and assess the risk associated with the debt instrument. Easy to Understand: - A credit rating is a simple code which is extremely easy to understand. Professional Competency: - Credit rating agencies embracing the required skill levels, credibility and competence, offering superior quality services makes it possible to employ scientifically analyzed and well researched opinion for ranking the different debt instruments. Low Cost: - The ratings provided by the credit rating agencies are not only important for the small and individual investors but are of utmost importance to the institutional investors. Moreover, it also facilitates a low cost appraisal system within the company. Efficient Portfolio Management: - Large investors may consider credit rating in order to diversify the portfolio. This can be done by selecting the most suitable instrument from a wide range of investment options. Such kind of investors may employ the data provided by the credit rating agencies in order to carefully identify the downgrades and upgrades. Based on the findings, the investors can alter their portfolio mix by functioning in the secondary market. Investment Decision: - The investment community also gets highly benefitted by the products and services offered by the credit rating agencies. In order to cite examples, products such as corporate reports, industry reports, seminars etc., help the financiers to make decisions pertaining to investment. Other Benefits: - Some of the other benefits of credit rating are that it safeguards the investors from getting bankrupt, helps in recognizing the risk, providing credulity to the instrument issuer, moreover the cost of information is also moderate. Major Credit Rating Agencies in the World There are several credit rating agencies in the world. However among them some of the most renowned agencies are MODDY’S, Standard & Poor’s and Fitch. Apart from these there are several other companies providing the credit rating services. Some of them are DBRS, Egan-Jones, A.M Best, Japan Credit Rating Agency Limited, Rating and Investment Information Inc, LACE Financial and Real point LLC among the others. The overviews of the major credit rating companies are provided below: - Moody’s Moody's Corporation, also known as Moody’s is involved in proving bond credit rating services to its clients. The company was founded in the year 1909 by John Moody. However, in the year 1962, the company was acquired by Dun & Bradstreet and hence spun off as a separate body and organized as Moody’s Corporation in 2000. Following the success and popularity, the company went on to establish Moody's Analytics in 2007. It is presently headquartered at 7 World Trade Center, New York City, United States. The Corporation has total revenue of $2.3 billion as of 2011 and presently employs around 6,700 people worldwide. It has presence in 28 countries of the world. Moody’s is considered as an essential constituent of the capital market, for providing research, credit ratings, tools and analysis which helps to integrate capital markets. Moody's Corporation is also the parent organization of Moody's Investors Service and Moody’s analytics. Moody's Investors Service offer services such as research and credit ratings of securities and debt instruments. On the other hand Moody's analytics offers advisory services, leading-edge software packages and financial risk management tools among others (Moody’s, 2013). Standard & Poor’s Standard and Poor’s (S&P) is an US based financial service corporation. S&P is a division of McGraw-Hill companies. The company mainly specializes in research and analysis on the bonds and stocks. The company is also known for the stock market indices like Italian S&P/MIB, Canadian S&P/TSX, U.S.-based S&P 500, India's S&P CNX Nifty and Australian S&P/ASX 200. The company was founded in the year 1860 by Daryl Lethbridge. It is presently headquartered at the New York City, United States. The company has presence in 23 countries of the world and employs around 10,000 people. It was reported that in the year 2009, the net revenue of the company was $2.61 billion. Moreover U.S. Securities and Exchange Commission has designated S&P as one of the nationally recognized statistical rating organization. Being a credit rating agency S&P issues credit ratings of the private and public corporations. The company issues both long term as well as short term credit ratings (Standardandpoors, 2013). Fitch Fitch group is an organization involved in providing credit rating services. The company is a subsidiary of Hearst Corporation and FIMALAC. The company operates with two headquarters. They are based in London, United Kingdom and New York City, United States. It was founded by John Knowles Fitch in the year 1913. Fitch is also one of the Nationally Recognized Statistical Rating Organizations (NRSRO). According to the reports the net revenue of the company in the year 2011 was around $732.5 million. Presently, the company operates with 50 offices around the world and has employee strength of 2,000 people. Fitch provides a wide range of professional services and industry leading products to the financial communities. Apart from providing proprietary market-based substances, it also distributes financial data, research and ratings by using a number of flexible platforms (Fitchratings, 2013). Some of the valuable products and services of the company are research services, pricing services, risk and performance analytics and tools for peer analysis and portfolio analysis. Rating Symbols of various agencies for bonds and stocks A credit rating is a process of evaluating the creditworthiness of stocks and bonds. Based on the assessment of credit worthiness, credit symbols are allocated. The rating symbols signify the probability of timely repayment of the interest and principal of a bond. In other words, the credit symbols illustrate the chances of the issuer to fulfill its obligations on time. In general a higher credit rating means high marketability to an issued share or bond. The rating symbols of stocks and bonds for the top three credit rating agencies are provided below: - Fitch Group Long term Credits Investment Grade Rating Signifies AAA Stable, Reliable and best quality companies AA quality companies, however the risk is higher from AA A Depends on the financial situation BBB Medium quality companies , however presently its condition is satisfactory Non-Investment Grade   BB Can get affected by the changes in economy B Noticeable Changes in the financial condition takes place CCC Largely dependent upon the present economic condition to meet customer demands CC Highly speculative and vulnerable bonds C highly vulnerable, or in bankrupt state, despite that still paying out some obligations D Failed to meet or fulfill the obligations and it is expected that the company will continue to default NR For the companies which are not traded publicly Short Term Credits Rating Signifies F1+ Best quality and exceptional capacity to fulfill the obligations. F1 Best quality and strong capacity to fulfill the obligations. F2 Good quality and satisfactory capacity to fulfill the obligations. F3 Fair quality and adequate capacity to fulfill the obligations, however depends upon the term condition. B Speculative in nature and issuer has minimal capacity to fulfill its commitment. C High possibility of defaulting. D Issuer is a defaulter and failed to meet the financial obligations. (Source: Langohr, & Langohr, 2010, p.51-53) Moody’s Investment Grade Rating Long term rating Short term rating Aaa Low credit risk and high quality Prime 1 Aa1 Very low credit risk and high quality High ability to pay back short term debt Aa2 Aa3 A1 Low credit risk and above average quality A2 Prime 2 A3 Best ability to pay back the short term debts Baa1 Medium Quality and moderate credit risk Prime 2 Best ability to pay back the short term debts Baa2 Prime 2/ Prime 3 High acceptable ability to repay in repaying short term debt Baa3 Prime 3 moderate ability to repay in repaying short term debt Non-Investment Grade Ba1 Significant credit risk Not Prime Ba2 Ba3 B1 High Credit risk B2 B3 Caa1 Very High credit Risk and poor quality Caa2 Caa3 Ca High chances of defaulting but there are possibility of recovering some amount of principal and interest C lowest quality and very less chances of recovering the interest and principal (Source: Franks, & Nunnally, 2010, p.163-165) Standard & Poor’s Long term Credits Investment Grade Rating Signifies AAA Extremely Strong capacity to meet the financial obligations AA Very Strong capacity to meet the financial obligations A Strong capacity to meet the financial obligations but somehow vulnerable to get adversely affected by changes in the economic condition BBB Adequate capacity to meet the financial obligations. However changing circumstances and adverse economic condition will weaken the ability to meet the financial obligations Non-Investment Grade   BB Vulnerable to the near term and faces major uncertainties to adverse economic condition B Vulnerable to the near term and faces major uncertainties to adverse economic condition but has the capacity to meet financial obligations CCC Vulnerable and dependent upon the present economic condition to meet customer demands CC Highly vulnerable C highly vulnerable, or in bankrupt state, despite that still paying out some obligations C1 Due on interest R Under regulatory Supervision in terms of its financial condition SD Defaulted on some obligations D Failed to meet or fulfill the obligations and it is expected that the company will continue to default NR For the companies which are not traded publicly Short Term Credits Rating Signifies A-1 Strong capacity to fulfill the obligations A-2 Satisfactory capacity to fulfill the obligations but dependent on the economical condition A-3 Adverse economic condition will weaken the capacity to meet the financial obligations B Speculative in nature and issuer has minimal capacity to fulfill its commitment C High possibility of defaulting D Issuer is a defaulter and failed to meet the financial obligations (Source: Mohan, & Elangovan, 2008, p.282) Methodology used in assessing the credit rating The methodology used in assessing the credit rating differs from one company to the other. Therefore there is no predefined methodology for providing credit ratings. In this context of the study, the methodology of Fitch Corporation will be elaborated to depict a credit rating methodology. The credit rating methodology of Fitch is dependent upon the areas such as industry review, organizational review, operational review, management review and financial review. The areas are detailed below. Industry review: - In order to rate a company, it is extremely important to get an idea of the position of a company in the industry, where it is functioning. This helps to understand the trends affecting the industry and also the how the individual company may get affected. The evaluating factors are: - 1. Barriers of entry 2. Intensity of competition. 3. Bargaining power of buyers and suppliers. 4. Legal, regulatory and accounting framework. 5. Basis of competitive advantage. Organizational review: - The organizational structure of the company can highly impact the cash flow, overall quality of credit and capital management. The factors of assessment for an organization are business synergies, upstream dividend requirements, flexibility & parent financial strength. Operational review: - In this context, a significant amount of qualitative assessment can be used to identify a company’s operation. The analysis mainly includes the past, present and predicted future state of the company. The areas of evaluation are distribution capabilities, market share, growth rate, brand quality and technological capabilities among others. Management review: - The review of a company’s management acts as an important factor towards its success. The factors which are considered in management review are strategic vision, track record and credibility of the company in terms of fulfilling obligations, appetite of risk, succession plans and risk management capabilities among others. Financial review: - Financial review is generally a qualitative assessment of the financial strengths of the company. Fitch Corporation considers management reports, financial statements and company projections to analyze the company’s financial position. The key areas of review are capital adequacy, investments, financial flexibility and operating performance. CAMEL Rating The CAMEL rating system can be defined as a method by which evaluation of the health of credit unions are carried out. It was adopted in the year 1987, and is basically based upon 5 important elements. The elements are basically (C) Capital, (A) Asset quality, (M) Management, (E) Earnings, and (L) asset Liability management. The rating system is designed in such a way that all the operational and financial factors are taken into account. Hence, to rate the credit unions, a combination of examiner’s judgment and financial ratios are employed. In general, CAMEL rating system is used for assessing the overall condition of banks. It is a supervisory rating of the United States regarding the situation of the US banks. The rating is generally based on the onsite assessment of the regulators and the financial statements as provided by the banks. The regulators are generally Federal Deposit Insurance Corporation, Federal Reserve, and Office of the Comptroller of the Currency. In this rating, a bank is generally provided with a number lying in the scale of 1 - 5. 1 being the most stronger and 5 signifies a weak position. However, this rating is not disclosed to the public, but the management of the banks only comes to know about it (Maechler, & McDill, 2003, p.23-24). On the other hand, CAMELS rating are generally a tool used by the US government, as a response to deal with the global economic slowdown of 2010. The primary intention of the US government was to determine whether or not to provide special help to a bank with the help of CAMELS ratings. The condition of the banks is determined based on the factors such as Capital adequacy, (A) Asset quality, (M) Management Capability, (E) Earnings, (L) Liquidity and (S) Sensitivity to Market Risk (Hafer, 2005, p.49). Figure 1 (Source: Glantz, 2003, p.379) Figure 2 (Source: Glantz, 2003, p.379) Issues Related to Credit Rating There are large numbers of issues related with the credit rating. However among them some of the major concerns are detailed below: - Circularity: - With the growing market of company issued debts, there has been increasing dependency and trust on the credit ratings. Nowadays, a number of bonds are issued along with its rating provided by the credit rating agency. In order to cite an example, a bond can be issued by paying 8 % coupon; however it comes with a clause which states that, if the bond’s rating goes below AA, the coupon will bear 12 %. These types of clauses are known as the trigger clause. Such phenomenon can lead to high amount of circularity. This is because, if credit rating agency downgrades the company’s to BBB, it will lead to payment of higher interest and will put an extra burden of extra interest payments. It may also downgrade company’s position. Global Inconsistency: - Some of the largest rating agencies of the world have their offices at different parts of the world. Moreover, in many cases the offices operate independently. Consequently, the branches at different places have to abide by rules and regulations of the operating country. This leads to an inconsistency in the rating process. Anticipation of Default: - The rating agencies are often accused of reacting after the event has taken place, rather than predicting the happenings. However, the credit rating agencies should make judgments on the basis of the instruction of the client company’s management. Nevertheless, if the client company has already perpetrated a fraud, then it will not be possible for the credit rating team to discover it. Therefore agencies need to be more aggressive in their investigation process. Rating Agency Power: - The decisions made by the rating agencies can impact the market of bonds to a large extent. This will not only affect the sales of bonds and shares, but will also discourage the holding of the bonds and may be forced to sell it. In addition, higher interest rates have to be paid (Christiansen et al., 2004, p.3-4). The issues can be best described by providing the example of Railtrack Group Plc. In this case one of the biggest credit rating agencies of the world, namely Standard & Poor's reduced the bond ratings of Railtrack Group Plc. This has happened after the UK government’s decision to give assurance to those bondholders, who discard some rights. Consequently, this has forced a number of investors to sell them at a reduced price. In the similar manner, bondholders of the Dutch food retailer, Ahold have to sell their bonds below the market price after Moody’s downgraded the credit rating of the company. References Chapman, S. (2013). The objective and importance of credit ratings. Retrieved from http://www.ehow.com/facts_5019129_objective-importance-credit-ratings.html. Christiansen, C., et al. (2004). An analysis of critique of methods used by rating agencies. Retrieved from http://www.actuaries.org.uk/system/files/documents/pdf/Sweeting.pdf. Fitchratings. (2013). About us. Retrieved from http://www.fitchratings.com/web/en/dynamic/about-us/about-us.jsp. Franks, S., & Nunnally, S. (2010). Barbarians of wealth: Protecting yourself from today's financial Attilas. Chichester: John Wiley & Sons. Glantz, M. (2003). Managing bank risk: An introduction to broad-base credit engineering. California: Academic Press. Gurusamy, S. (2009). Indian financial system (2nd ed.). Noida: Tata McGraw-Hill Education. Hafer, R. (2005). The Federal Reserve System: An encyclopedia. Westport: ABC-CLIO. Langohr, H., & Langohr, P. (2010). The rating agencies and their credit ratings: What they are, how they work, and why they are relevant. Chichester: John Wiley & Sons. Maechler, A. M., & McDill, K. (2003). Dynamic depositor discipline in U.S. banks. Washington D. C.: International Monetary Fund. Mohan, S., & Elangovan, R. (2008). Financial services. New Delhi: Deep and Deep Publications. Moody’s. (2013). Moody’s Corporation. Retrieved from http://www.moodys.com/Pages/atc.aspx. Standardandpoors. (2013). About us: Standard & Poor’s Rating Services. Retrieved from http://www.standardandpoors.com/about-sp/main/en/us. Bibliography Alessi, C. (2012). The credit rating controversy. Retrieved from http://www.cfr.org/united-states/credit-rating-controversy/p22328. Skreta, V., & Veldkamp, L. (2009). The origin of bias in credit ratings. Retrieved from http://www.voxeu.org/article/origin-bias-credit-ratings. Smeworld. (2013). Recent trends in credit rating; corporate governance. Retrieved from http://www.smeworld.org/story/sme-finance/recent-trends-credit-rating.php. UNCTAD. (2008). Credit rating agencies and their potential impact on developing countries. Retrieved from http://unctad.org/en/Docs/osgdp20081_en.pdf. Read More