Credit rating

The biggest risk an investor in debt runs is simple: the borrower does not pay. That risk of default is the borrower's credit risk.

A lender could evaluate it themselves, and a bank does. A retail investor buying a debenture cannot. So the market delegates the work to credit rating agencies, which must be registered with SEBI and follow the SEBI (Credit Rating Agencies) Regulations, 1999.

The agency gathers qualitative and quantitative information — not only from the borrower but from other sources — puts it to industry experts, and has a rating committee assign the rating. The workbook's description of what a rating is worth repeating: an exercise that converts the ability and willingness of the company to service the instrument into a symbol.

SEBI has standardised the symbols so an investor can read risk across agencies. Every symbol carries the agency's first name as a prefix.

Long term — instruments with original maturity exceeding one year:

Modifiers + / − may be used for the categories AA to C only.

Short term — original maturity up to one year: A1, A2, A3, A4 and D, with a + modifier only, usable for A1 to A4.

Debt mutual fund schemes take the same scales with an mfs suffix. Instruments with explicit credit enhancement take a CE suffix. SEBI has also introduced an Expected Loss based rating scale for projects and instruments in the infrastructure sector.

A rating is dynamic. Agencies must constantly monitor the factors affecting the instrument and reassign the rating if credit quality improves or deteriorates. Where compliances crucial to the rating are still outstanding, or documentation remains to be executed, the rating is provisional and must be prefixed "provisional" in the rating letter, press release and rating rationale.

Two companies each raise Rs 100 crore through a five-year NCD in the same week.

The rating differential costs Company B Rs 1.75 crore a year — Rs 8.75 crore over the issue. That is the price of a symbol, and it is why issuers care about ratings at least as much as investors do.

Now suppose Company B is downgraded from A to BBB in year three. Nothing in the debenture changes — the coupon is still 9.30 percent on Rs 100 face value, and the registrar pays exactly the same warrants. What changes is the market price, because a buyer now demands a higher yield for moderate credit risk. An investor who has to sell before maturity absorbs that as a capital loss.

And if Company B had chosen not to get rated at all, the workbook's point applies: unrated instruments are more illiquid, so their yield is higher still — a cost, not a saving.

Chapter 3.6 (Credit Rating), which reproduces the SEBI rating symbols in full, and Chapter 3.6.1 on unrated bonds. This is one of the most reliably examined sections in the paper: which symbol carries the lowest credit risk, where the long-term/short-term boundary falls (one year), which categories take the +/− modifiers, and what "provisional" means.

• Modifiers apply to AA through C only on the long-term scale — never to AAA, never to D. On the short-term scale only the + modifier exists, for A1 to A4.
• A rating is assigned to an instrument, not to a company. The same issuer can carry different ratings on different instruments, and a short-term rating is on a different scale from a long-term one.
• "D" covers both actual default and expected default. It is not a post-mortem grade.
• Unrated does not mean safe or unsafe — it means unrated, and therefore more illiquid and higher yielding. SEBI has separate guidelines for mutual funds investing in unrated debt.
• A rating is not a recommendation to buy, and it is not permanent. SEBI requires continuous monitoring and reassignment; candidates who treat a rating as a fixed attribute of the bond get the "dynamic" question wrong.
• Government securities carry no credit or default risk, so the rating scale is not applied to them.