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SEBI circular dated June 13, 2019, has made it imperative for Rating Agencies to assign a suffix of (CE) in respect of Ratings, which are supported by Explicit Credit Enhancement. Acuité believes that this step will help in establishing linearity across the methodologies adopted by various rating agencies. The increasing number of ratings based on such Credit enhancements especially in higher rating categories renders importance to such uniformity; especially as mostly in such cases, there is a significant divergence between the standalone credit profiles of the borrowers vis-a-vis the ratings assigned based on such explicit credit enhancements. Such instruments/ structures shall have a suffix of 'CE' after the rating.
Acuité believes that the structures /instruments backed by Explicit Credit Enhancement shall mean and include any of the following. The list is inclusive and not exhaustive.
1.Bonds/ Loans backed by Debt Service Reserve Account (DSRA) and Escrow Arrangement/ Structured Payment Mechanism (SPM) where there is undertaking by a third party for replenishment of DSRA.
In case of a structure based on the creation of a DSRA, i.e. backed by liquid asset collateral such as FD, or G-sec bonds, the quantum of funds in the TRA (Trust & Retention Account)/ Escrow Account and the DSRA are to be evaluated in line with the total amount of debt to be serviced on each due date. The presence of an escrow account by itself does not guarantee the adequacy of funds for servicing. However, a strictly executed escrow arrangement can be useful for trapping the cash flows and utilising them as per the priority (waterfall mechanism) for meeting the debt servicing requirements.
Typically, a higher cover in the form of DSRA is representative of a high degree of safety & eligible for higher notch up. Acuité recognises the fact that funds placed in the DSRA are often associated with high opportunity costs, and thus increase the effective cost of borrowing for the issuer. The presence of a DSRA along with a SPM (which could be in the form of a T- n day structure) differentiates the instrument from other plain vanilla borrowings (without these features), as the likelihood of slippages in payments is mitigated due to such clauses. The presence of a corporate guarantee or a DSRA Replenishment Undertaking by a third-party acts as a credit support, so that in the event of the DSRA being utilised, the third party shall replenish the DSRA or make the requisite payment (as per the guarantee/ undertaking document) after the demand/invocation notice by the lender or debenture trustee. Acuité will also conduct an independent credit assessment of the third party who has provided the undertaking/ guarantee. The ability of the third party to meet their obligations under the undertaking is also assessed.
The ratings based on such structures is suffixed with the words CE in parenthesis subject to the presence of a T-n structure in the Undertaking besides the other factors like irrevocability and unconditionality..( T-n indicating thatif T is the due date for any payment of interest/ principal, then the issuer of the Undertaking commits to ensure funding in the account if the account is not funded ‘n’ days before the due date). The CE Suffixindicates that the rating factors in support in the form of external explicit credit enhancement. Even in the absence of T -n structure in the Undertaking, Acuite may still factor in support from the guaranteeing entity ( albeit without a CE suffix). The understanding is that the entity issuing the undertaking may still continue to support the borrowing entity though there is no explicit clause in the undertaking for timely support.
Loans & Borrowings with DSRA & Escrow mechanism without replenishment undertaking/guarantee by third party
In case, even where there is no replenishment undertaking by a third part, Acuité may still consider the presence of a DSRA & Escrow account (along with a T structure) as an Internal Credit Enhancement factor in the benefits accruing from such arrangements. The ratings in such cases will not consider the suffix CE. However, Acuité will mention in its analytical approach that it has relied on the presence of a structure while arriving at the final rating.
2.Bonds / Loans backed by Partial / Full Guarantees / Letters of Comfort from Corporates/ Banks/ Sovereign Governments/ State Governments/ Government backed Financial institutions
In such mechanisms, there exist an external entity (typically a corporate / or a government/or a Bank ) that undertakes to fulfil the debt repayment obligations on behalf of the issuer of the instrument/borrower in case of an invocation of the guarantee, the necessary funds are not made available before the due date./
In this regard, if considered necessary, Acuité may, examine the guarantee deed in to ascertain the following aspects
·Unconditional & Irrevocable Nature of Guarantee
·Guarantee is Continuing in nature .Whether the guarantee covers the entire tenure of the instrument and also covers the interest and principal part of the instrument/ loan
·Clause providing for payment on first demand without any protest
·Possibility of any operational/ regulatory risks that could inhibit the guarantor from discharging the obligations under the guarantee, should such a situation arise
·Timelines for invocation & payment upon receipt of invocation notice
·Legal opinion from an independent law firm regarding the various aspects such as enforceability, unconditional & irrevocable nature etc.
In respect of debt obligations (credit facilities availed from banks/ Capital market instruments) backed by Bank Guarantees/ Standby Letters of Credit from Banks/ Financial Institutions, the ratings will be linked to the credit quality of the Guaranteeing /SBLC issuing Bank. In such cases of Bank guarantee / SBLC backed structures, in addition to its own assessment, Acuité may rely on external ratings assigned by other rating agencies to these banks/ financial institutions. In case of more than one rating, Acuité will generally consider the lowest rating. In case of overseas banks/ institutions, Acuité may map the international rating of the bank to the domestic scale and then assign a rating based on the domestic equivalent of the bank's rating. Acuité may suitably maintain a differential of 1-2 notches to the guaranteeing bank's rating /domestic equivalent rating. It is to be noted that such ratings are based on the credit quality of the guaranteeing bank and any revision in the credit rating of the said bank will result in a revision of the CE ratings assigned for the facilities/borrowings.
Acuité observes that Bank guarantees/SBLCs are issued by banks as per pre-defined standardized formats and are usually post default in nature i.e. the lender generally invokes the guarantee /SBLC only after the occurrence of default. There is no T-n Structure in such guarantees Notwithstanding the absence of T-n clauses, the ratings assigned to such credit facilities will be suffixed with the words (CE) i.e. Credit Enhancementto indicate that these ratings do not reflect the standalone credit quality of the borrower/issuer and are based on certain forms of credit enhancement from the bank. The reason for adopting this approach in respect of bank guarantee supported borrowings (vis a vis borrowing supported by Corporate/ State Government Guarantees as above) is that such guarantee/SBLC issuances are part of bank’s core activity. Typically, under these guarantees, the bank undertakes to pay the amount within a pre-agreed time after invocation. Any instance of non-payment by the bank/delays in payment after receipt of invocation notice, can have adverse implications for the issuing bank’s credibility. As opposed to such guarantees, the presence of corporate guarantee does not ensure that ultimate payment will be received in a timely manner even after invocation.
In view of such stringent clauses, the lending Bank/investor reckons such exposures as an exposure on the guaranteeing bank & the risk weightage assigned to such exposures will be based on the rating of the guaranteeing bank.
Acuité has observed that, the invocation of guarantees especially in case ofdebt availed from banks/financial institutions is a post default event. Acuité focusses more on the post invocation timelines such as the date by which the funds will be made available post serving of invocation notice. Acuité also examines the time lines for intimation to the rating agency especially in case of debt (NCDs etc.) with debenture trustees.
In cases where there are no explicit corporate guarantees (i.e. legally enforceable obligation), Acuité may rely on other supports such as Letter of Comfort. The key aspects to be reckoned here would be the intent of the counterparty's management in supporting the timely servicing of the debt obligations and the criticality of the arrangement to the counterparty's operations. Such structures will not be suffixed with a CE since there are no (T-n) structures and even if the management decides to incorporate such structure, the legal enforceability of the LoC presents a challenge.
3.Structures Based On Pledge of Liquid Securities Including Shares
A. Structures based on Pledge of Shares
The increasing trend in offering security coverage in the form of shares/ liquid investments has prompted a need for looking at such structures differently as opposed to structures based on a security of movable/ immovable assets. Generally, a rating is indicative of a probability of default and is generally unaffected by the collateral coverage. However, in cases of structures backed by liquid collateral, a right type of structure can mitigate the likelihood of default.
Against this backdrop, Acuité assesses such structures in a different manner as opposed to plain vanilla borrowings. Such structures are very common in case of borrowings by investment vehicles of promoters. It has been observed that generally promoters of listed companies prefer to hold their investments in their listed companies through a clutch of privately held companies. Typically, these private companies have moderate revenue streams mainly by way of dividends on the shares/ interest on investments. Such companies are structured as vehicles for promoter holding and typically do not have any other operations; their net worth and any debt requirements are for investments in promoter group companies. In the absence of any operations, these companies do not have any source of sustainable cash flow, they often go in for refinancing of their debts/ infusion of funds by promoters. Hence, refinancing ability/ financial flexibility is critical in evaluating such companies. Their financial flexibility is directly linked to the market valuation of their investment portfolio.
Acuité's approach to evaluation of such issuers is based on the standalone credit profile of the issuer which would then be notched up for the structure. The extent of notching up will depend on two broad platforms (i) Strength of the Structure (ii) Nature and Quantum of liquid collateral
Strength of Structure
Timelines for funding the account are generally spelt out in the financing document in terms of T-n days (where T is the due date). Typically, n ranges between 3-5 days in most of the cases, since it provides adequate time to the lender/ debenture trustee to initiate the process for selling the securities and ensuring that the funds are received in the account on the due date.
Secondly, tolerance for any dilution in security coverage is also a critical factor in evaluation of such structures. In case of structures backed by pledge of equity shares, if the security coverage falls below the minimum acceptable coverage stipulated in the term sheet, then an immediate top up must be arranged. Acuité believes that for such structures, any significant tolerance below the stipulated coverage beyond five consecutive trading days will render the structure infructuous. Needless to say, monitoring by the lender of the asset coverage on a periodic basis and initiating action for topping up wherever necessary is crucial in such structures. Hence, Acuité will examine the financing documents for these clauses.
Nature & Quantum of Liquid Collateral
Among other factors, Acuité also examines the following aspects while arriving at a notching up:
1) Market Capitalisation & Financial performance of the companies, whose shares are being offered as collateral
2) Volatility in the share prices
3) Financial Flexibility in the form of unencumbered shares available with the (borrower) promoter vis a vis pledge-based borrowing
4) Quantum of unencumbered promoter holding vis-a-vis encumbered promoter holding
The ratings on borrowings based on pledge of shares / securities/other liquid assets will be suffixed with CE in parenthesis after the rating
B. Structures based on pledge of highly rated bonds/ debt Securities (both Government securities & Private bonds)
Acuité observes that certain instruments/ bank facilities secured by a pledge of Government Securities/ and highly rated bonds/ debentures issued by private corporate bodies and PSUs are increasingly gaining acceptance. The key borrowers under these instruments will be traders in government securities/ corporate bonds. These facilities are virtually credit risk free since the lender can easily liquidate the underlying securities without any significant price concession and recover the entire dues.
High credit quality of the Underlying security ( i.e AA - & above)
The Securities issued by Government of India are almost risk free in terms of their AAA Rating due to the sovereign status of the issuer. However highly rated securities issued by other entities like private corporates / PSU undertakings/ State Governments are at an elevated risk of deterioration in credit quality (usually evidenced by downgrade in the rating) over a medium to long term. Hence the key aspect to be examined is the extent of exposure to Non- Central Government securities permissible under the borrowing arrangement.
Liquid nature of the Security
Generally, the market for government securities is highly liquid mainly on account of their risk-free status and significant market participation in the form of players like primary dealers, mutual funds and most importantly banks (for Statutory Liquidity Ratio requirements). Within the government securities segments, certain segments have slightly higher liquidity than others depending on the tenor, pricing and quantum of paper available. As against government securities, the market for corporate bonds and other securities is relatively shallow since most of the long-term investors in these bonds/ Securities prefer to stay invested till maturity. Besides the shallow nature of the counter, the liquidity in a bond/ debenture can also be impacted by changes in the credit quality of the borrower. Sharp credit cliffs (i.e downgrade by several notches) can also trigger a liquidity issue on a counter.
Availability of adequate margin to mitigate the risk of volatility over a single time period
Generally, the lenders will prefer some "skin in the game" of the borrower, which will be stipulated by way of margin requirements. Typically, the margin will be linked to the volatility over a given time period, based on past historical data. The volatility in prices of government securities is a function of factors like liquidity, interest rate announcements, size of borrowing programme, economy wise macro factors etc. Since the list of securities eligible for drawing under such facilities, includes a mix of central government securities as well as other securities including private securities, the actual margin stipulation is higher keeping in mind the probability of higher credit losses under the private sector can portfolio. The availability of adequate margin is a critical factor to be considered in this aspect Similar to ratings on share pledge-based facilities, the ratings assigned to the structures based on pledge of debt securities will be suffixed with the words (CE) indicating that the rating factors in support from the presence of high-quality liquid collateral available to the lender & the flexibility available to the lender to recover his dues at a short notice.
Besides the above-mentioned categories, the ratings on following categories of instruments/ borrowings will also be suffixed with the words CE:
|
Type of Instrument / Structure |
Rationale for CE suffix |
|
CMBS-like structures |
External credit enhancement |
|
Covered bonds, which have to be serviced primarily by the issuer, with secondary recourse to the cash flows from the pool of loans housed in a trust |
External credit enhancement |
|
Partially guaranteed bond |
External credit enhancement |
|
Shortfall undertaking backed bond/ loan or other such third-party credit enhancement |
External credit enhancement |
|
Guaranteed pooled loans issuance (PLI) / Pooled bond issuance (PBI), not through a trust |
External credit enhancement |
The long term and short-term rating scales are presented below:
|
Long Term Rating symbol |
Descriptor |
|
AAA (CE) |
Highest Safety, Lowest Credit Risk |
|
AA (CE) |
High Safety, Very Low Credit Risk |
|
A (CE) |
Adequate Safety, Low Credit Risk |
|
BBB (CE) |
Moderate Safety, Moderate Credit Risk |
|
BB (CE) |
Moderate Risk, Moderate Risk of Default |
|
B (CE) |
High Risk, High Risk of Default |
|
C (CE) |
Very High Risk, Very High Risk of Default |
|
D (CE) |
Default / Expected to be in Default soon |
|
Acuité may apply '+' (plus) or '-' (minus) signs for ratings from 'Acuité AA (CE)' to 'Acuité C (CE)' to reflect comparative standing within the category. |
|
|
Short Term Rating Symbol |
Descriptor |
|
|
A1 (CE) |
Very Strong degree of Safety, Lowest Credit Risk |
|
|
A2 (CE) |
Strong degree of Safety, Low Credit Risk |
|
|
A3 (CE) |
Moderate degree of Safety, Higher Credit Risk as compared to instruments rated in the two higher categories |
|
|
A4 (CE) |
Minimal degree of Safety, Very High Credit Risk |
|
|
D (CE) |
Default / Expected to be in Default on Maturity |
|
|
Acuité may apply '+' (plus) sign for ratings from 'Acuité A1 (CE)' to 'Acuité A4 (CE)' to reflect comparative standing within the category. |
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