RATINGS AS PORTFOLIO

MANAGEMENT SUPPORT TOOL

FOR ISSUER SELECTION
Andr Braz
Portfolio Manager
Santander Asset Management
February 26, 2015

RATINGS
Introduction
Sovereign Ratings
Corporate Ratings
Conclusion

Q&A

RATING
Introduction
Sovereign Ratings
Corporate Ratings
Conclusion

Q&A

STOCK OF GLOBAL FINANCIAL ASSETS

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GLOBAL POOL OF FUNDS - 2013 ESTIMATES

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US AND EUROPE DEFAULT RATES

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RATING DRIFT

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RATING DYNAMICS

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RATING DYNAMICS - EURO CREDIT SPREADS BY

RATING

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CREDIT RATINGS
A credit rating estimates the credit worthiness of an a financial security, a
corporation, local government or even a country.
It is an evaluation made by credit reporting agency of a risk of buying into a
specific security offering and based on a number of factors.
Credit ratings are calculated from financial history and current assets and
liabilities.
Typically, a credit rating tells a lender or investor the probability of the
subject being able to meet payment requirements for interest and principal
repayment.

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WHAT IS A CREDIT RATING

An opinion on the issuers capacity to meet its financial
obligations on a particular issue in a timely manner, for example
long-term bonds:

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FUNCTIONS OF A CREDIT RATING AGENCY

Provide easy to understand information: Rating agencies gather information,
then analyze information to interpret and summarize complex information in
a simple and readily understood manner.
Provide basis for investment: An investment rated by a credit rating enjoys
higher confidence from investors. Investors can make an estimate of the risk
and return associated with a particular rated issue while investing money in
them.
Healthy discipline on corporate borrowers: Higher credit rating to any credit
investment makes the financial instrument (bond, mortgage security) more
attractive to investors. Corporations can borrow money more cheaply if they
maintain high credit ratings on their debt.
Formation of public policy: Once the debt securities are rated professionally,
it would be easier to formulate public policy guidelines as to the eligibility of
securities to be included in different kinds of institutional portfolios.

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RATING CATEGORIES
Investment grade refers to the safest levels
of financial securities.
Investment-grade securities have historically
exhibited relatively low rates of default.

Speculative grade, or noninvestment grade,

refers to the riskier securities.
Debt rated BB (Ba for Moodys) or below is
noninvestment grade, and is sometimes referred
to as high yield or junk.
Default rates among these classes of securities are
comparatively high.

Within the major rating categories (AA, A,

etc.), credit ratings are often modified to
show relative standing within a category.
Moodys uses numbers 1, 2, and 3, while
S&P and Fitch use plus (+) and minus ()
signs.

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RATINGS
Introduction
Sovereign Ratings
Corporate Ratings
Conclusion

Q&A

SOVEREIGN RATINGS OVERVIEW

USD 50 trillion in outstanding sovereign debt is guided by sovereign credit
Just three firms (Moodys, S&P and Fitch) dominate the market (95%)
They set ratings based on a combination of measurable fundamentals (the
objective component) and the judgment of their in-house ratings committees
(the subjective component)
Credit Ratings Agencies (CRAs) have to predict the probability of sovereign
default

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MOODYS CASE
Moodys employ 31 variables (so-called sub-factors) to determine the
ranking. The value for each sub-factor is assigned a rank on a 15-point scale
from Very High plus to Very Low minus. There appears to be little or no
empirical foundation for the cut-offs between these ranks. These sub-factors
are then aggregated using a set of ad-hoc weights. The final rating is based
on the quantitative assessment and the judgment of their rating committees.

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S&P CASE
S&P's methodology appears similar to Moody's although less transparent.
More specifically, each sovereign is given a score from one (the strongest) to
six on each of the following five criteria: political, economic, external, fiscal
and monetary. Although there is a list of variables taken into consideration,
many of them are not defined explicitly and there is little or no discussion of
the weights used. Indeed, the agency says that, rather than providing a
strictly formulaic assessment, Standard & Poor's factors into its ratings the
perceptions and insights of its analysts.

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FITCH CASE
Fitch employs a number of variables in its sovereign ratings model. These
variables are listed under four headings: macroeconomic, public finances,
external finances, and structural. The weights are estimated using regression
analysis. However, just like Moodys and S&P, Fitch says that the actual
rating determined by the sovereign rating committee can and does differ
from that implied by the rating model". Subjectivity plays an important role.

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TYPICAL OBJECTIVE COMPONENTS

Nominal GDP,
GDP per capita
Average real GDP growth
Public debt
Current account
External debt
An indicator variable for whether the state has a past default
An indicator variable for whether the state is an advanced country
Government effectiveness
Rule of law
Inflation
Inflation volatility
The budget balance
The public debt trend
World Banks control of corruption index

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Statistically
significant for
explaining the
sovereign
ratings

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RATINGS
Introduction
Sovereign Ratings
Corporate Ratings
Conclusion

Q&A

CORPORATE RATINGS OVERVIEW

Credit rating depends on several factors, some of which are
tangible/numerical and some of which are judgmental and intangible. These
factors include:
Overall fundamentals and earnings capacity of the company and volatility of the same.
Overall macro economic and business/industry environment.
Liquidity position of the company (as distinguished from profits).
Requirement of funds to meet irrevocable commitments.

Financial flexibility of the company to raise funds from outside sources to meet temporary
financial needs.
Guarantee/support from financially strong external bodies.
Level of existing leverage (borrowings) and financial risk.

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S&P CREDIT RATING PROCESS

Example of a rating process:
The issuer of a financial product requests a
rating
The rating agency does an initial evaluation

This may include meetings with

an issuers management team
The financial product is reviewed
The analysis is reviewed by a
rating committee
Once a rating is assigned the
issuer is notified
Ratings are then distributed to
the public

Rating agencies then monitor the issuers and

reports adjustments.

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RATING METHODOLOGY
The methodology for creating a rating involves an analysis of all the factors
affecting the creditworthiness of an issuer company: business, financial and
industry characteristics, operational efficiency, management quality, competitive
position of the issuer and commitment to new projects:
A detailed analysis of the past financial statements is made to assess the performance and to
estimate the future earnings.
The companys ability to service the debt obligations over the tenure of the instrument being rated is
also evaluated.
In fact, it is the relative comfort level of the issuer to service obligations that determine the rating

A rating analysis includes the following factors:

1. Business Risk Analysis
2. Financial Analysis
3. Management Evaluation
4. Geographical Analysis
5. Regulatory and Competitive Environment
6. Fundamental Analysis

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BUSINESS RISK ANALYSIS

Industry risk: The rating agencies evaluates the industry risk by taking into consideration various
factors like strength of the industry prospect, nature and basis of competition, demand and supply
position, structure of industry, pattern of business cycle etc.
Industries compete with each other on the basis of price, product quality, distribution capabilities
etc.
Industries with stable growth in demand and flexibility in the timing of capital outlays are in a
stronger position and therefore enjoy better credit rating.
Market position of the company: Rating agencies evaluate the market standing of a company taking
into account:

Percentage of market share

Marketing infrastructure

Competitive advantages

Selling and distribution channel

Diversity of products

Customers base

Research and development projects undertaken to identify obsolete product

Quality Improvement programs

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BUSINESS RISK ANALYSIS - CONTINUED

Operating efficiency: Favorable locational advantages, management and labor relationships,
cost structure, availability of raw-material, labor, compliance to pollution control programs,
level of capital employed and technological advantages etc. affect the operating efficiency of
every issuer company and hence the credit rating.
Legal position: Legal position of a debt instrument is assessed by letter of offer containing
terms of issue, trustees and their responsibilities, mode of payment of interest and principal in
time, provision for protection against fraud etc.
Size of business: The size of business of a company is a relevant factor in the rating decision.

Smaller companies are more prone to risk due to business cycle changes as compared to larger companies.

Smaller companies operations are limited in terms of product, geographical area and number of customers.

Whereas large companies enjoy the benefits of diversification owing to wide range of products, customers spread over
larger geographical area.

Business analysis covers all the important factors related to the business operations over an
issuer company under credit assessment.

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RATING METHODOLOGY
Financial Analysis: Financial analysis is used to determine the financial strength of the issuer
company through quantitative means such as:

ratio analysis

cash flow analysis

study of the existing capital structure.

Both past and current performance is evaluated to comment the future performance of a company
This includes an analysis of four important factors namely:

Accounting quality: As credit rating agencies rely on the audited financial statements, the analysis of statements begins with the study
of accounting quality.

This includes: qualification of auditors, overstatement/understatement of profits, methods adopted for recognizing income, valuation
of stock and charging depreciation on fixed assets are studied.

Earnings potential/profitability: Profits indicate companys ability to meet its fixed interest obligation
in time.

A business with stable earnings can withstand any adverse conditions and also generate capital resources internally.

Profitability ratios like operating profit and net profit ratios to sales are calculated and compared with last 5 years figures or compared
with the similar other companies carrying on same business.

As a rating is a forward-looking exercise, more emphasis is laid on the future rather than the past
earning capacity of the issuer.

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CASH FLOW AND FINANCIAL ANALYSIS

Cash flow analysis: Cash flow analysis is undertaken in relation to debt and fixed and working
capital requirements of the company.

Indicates the usage of cash for different purposes and the extent of cash available for meeting fixed interest obligations.

Cash flows analysis facilitates credit rating of a company as it better indicates the issuers debt servicing capability
compared to reported earnings.

Financial flexibility: Existing Capital structure of a company is studied to find:

The debt/equity ratio, alternative means of financing used to raise funds, ability to raise funds, asset deployment potential
etc.

The future debt claims on the issuers as well as the issuers ability to raise capital is determined in order to find issuers
financial flexibility.

Management Evaluation: Any companys performance is significantly affected by:

Management goals, plans and strategies

Capacity to overcome unfavorable conditions

Staffs own experience and skills, planning and control system etc.

Rating of a debt instrument requires evaluation of the management strengths and

weaknesses.
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ADDITIONAL ANALYSIS
Geographical Analysis: Geographical analysis is undertaken to determine the locational
advantages enjoyed by the issuer company.

An issuer company having its business spread over large geographical area enjoys the benefits of diversification and hence
gets better credit rating.

A company located in backward area may enjoy subsidies from government thus enjoying the benefit of lower cost of
operation.

Thus geographical analysis is undertaken to determine the locational advantages enjoyed by the issuer company.

Regulatory and Competitive Environment: Credit rating agencies evaluate structure and
regulatory framework of the financial system in which it works.

While assigning the rating symbols, CRAs evaluate the impact of regulation/deregulation on the issuer company.

Fundamental Analysis: Fundamental analysis includes an analysis of liquidity management,

profitability and financial position, interest and tax rates sensitivity of the company.

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RATINGS
Introduction
Sovereign Ratings
Corporate Ratings
Conclusion

Q&A

BENEFITS OF RATINGS
For Companies

For Investors

Market access (gate keeping)

Due diligence efficiency

Expands breadth of market

Multiple independent perspectives

Widens distribution

Facilitates comparisons

Improves liquidity

Tool in portfolio management

Improves pricing

Enhances secondary market liquidity

Helps management with

independent, outside perspective
on company

Relatively stable over time

Basis for performance benchmarks

Helps management monitor

counterparty risk

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DISADVANTAGES OF CREDIT RATING

Credit rating suffers from the following limitations:
Non-disclosure of significant information
Static study
Rating is no certificate of soundness
Rating may be biased
Rating under unfavorable conditions
Difference in rating grades
Improper Disclosure May Happen
Impact of Changing Environment
Problems for New Companies
Downgrading by Rating Agency

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Thank You
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