Criteria For Rating Commercial Paper
9th October 2019 (Version 3)


Overview

Commercial Paper (CP) is an unsecured money-market instrument, issued by corporate borrowers, financial institutions and primary dealers to raise short-term funds (usually ranging between 7 to 365 days) for funding working capital requirements. In India, CP has traditionally been used as a low-cost instrument to replace working capital borrowings from the banking system. In recent years, highly-rated non-banking financial companies (NBFCs) have also started accessing CP in a large way to meet their short-term funding needs resulting in NBFCs and financial institutions accounting for around 60 per cent of CP issuers. 

CP has several inherent risks. While some of these are specific to the instrument, many others are about the entity being rated. More often than not, entities have a tendency to rollover and refinance their CP Issue as a regular long term practice, warranting a long term view along with the short term. 

To this effect, Acuité believes that the process of rating a CP Issue not only involves assessing the fundamental risks in the entity, but also ascertaining the structural (instrument specific) risks in the issue. This largely covers liquidity and refinancing risk apart from credit enhancement mechanisms (if any).

Scope

This document outlines Acuité's approach towards rating of Commercial Paper and covers the following.

  • Part I: Understanding the fundamental risks of the entity being rated 
  • Part II: Translation of long term risk indicators onto a short term scale 
  • Part III: Evaluating the structural and instrument-specific risks with credit enhancement mechanisms, if any.
  •  

    Methodology for Rating Commercial Paper Issues

    The three stage process for rating CP Issue is given below: 

    • Assessing Long Term Credit Risk

    • While CP is a short term instrument, since it is generally rolled over on maturity, it tends to remain afloat on a long term basis. In case the issuer fails to rollover the CP, the issuer's ability to refinance the CP is a function of its long term credit risk as the issuer must depend on fresh borrowings from Financial Institutions/banks or from the capital markets to prevent default on its CP related obligations. Therefore, the long term credit rating is indicative of the refinancing risk and the roll-over (or repricing) risk inherent to an issuing entity. 

      In order to assess the long term credit risk of the issuer, Acuité believes that an organisation needs to take into account three primary sources of risk:

      • Business Profile: Business Risks are a function of the entity's market position and operating efficiency apart from being exposed to the systemic risks in the industry in which the entity operates.
      • Financial Profile: The Financing mix, the strength and weakness of the financials and the financial structure of the entity along with stability of earnings, profitability and the margins, design of various sources of funding and the funding instruments along with the entity's liquidity and resource mobilization ability are evaluated to understand the financial risk inherent in the entity.
      • Management Profile: The management's ability to adequately capitalize on its financial structure, the corporate governance practices adopted, competence, integrity and risk appetite are the factors that Acuité takes into consideration to evaluate the inherent management risk in the entity.
      • Project Risk: Under Project Risk, the entity's ability to manage a significant project, in terms of funding requirements and implementation capabilities is analyzed. Acuité also evaluates the track record of the entity with regard to successful completion and commissioning of large projects. 

      Acuité places special emphasis on understanding the liquidity risk of the issuer, the long term resource mobilization ability and financial flexibility.

       

    • Long Term Liquidity Risk and Resource Mobilisation Ability
    •  

      After arriving at the long term rating, Acuité believes that it is imperative to evaluate the issuer's liquidity position and stability in the periodic cash flows. To this effect, two key aspects are analyzed:

      • The monthly working capital limit utilization during the last six to 12 months
      • Projected cash flows in the short to medium term 

      Commercial Paper issues tend to be refinanced and thus Acuité believes that it is imperative to analyze the entity's ability to refinance its CP issue on expiry – either by rolling over the issue or through alternative sources of funding. Acuité adopts a three stage approach to ascertain the same:

      • Assessment of the un-utilized working capital limits: It is observed that entities with lower levels of utilization, on a consistent basis, warrant higher ratings especially if the un-utilized limit is sufficient to cover the size of the issue.
      • Assessment of the Issuer's ability to raise funds at a short notice:Generally, entities that enjoy better relationships with banks/financial institutions (FIs) and have good repayment / financial track-record are able to raise funds at a short notice. Besides, the following factors also enable such entities to easily raise funds – 
        • Presence of high-quality / liquid assets that can easily be accepted as primary security or collateral by banks and FIs
        • Support and commitment from the promoters, group entities or any other entity
      • Assessment of the Current Liquidity Levels: Historical presence of adequate high quality liquid assets and commitment to maintain them in future reduces the degree of liquidity risk in the entity.

       

    • Translating the Long Term Rating to the Short Term Scale
    •  

      Acuité-assigned Short Term Ratings are dependent on the Long Term Ratings. Given below is the two-step processfollowed by Acuité to map the ratings.

       

    • Firm Specific Adjustments in Short Term Ratings
    •  

      Acuité may assign a higher or lower credit rating as against the base case mapping model presented below, to account for substantial differences in an entity's liquidity profile. For instance, availability of comfortable short term liquidity in the form of cash collateral or liquid investments or any other similar factor reduces the short term liquidity risk of the entity. Acuité may take an upward deviation and assign a higher short term rating for a particular long term rating as indicated in the mapping model below.

       

    • Base Case Mapping Framework:
    •  

      Long Term 
      Rating

      Short Term 
      Rating

      Acuité AAA

      Acuité A1+

      Acuité AA+

      Acuité AA

      Acuité AA-

      Acuité A+

      Acuité A1

      Acuité A

      Acuité A-

      Acuité A2+

      Acuité BBB+

      Acuité A2

      Acuité BBB

      Acuité A3+

      Acuité BBB-

      Acuité A3

      Acuité BB+

      Acuité A4+

      Acuité BB

      Acuité BB-

      Acuité B+

      Acuité A4

      Acuité B

      Acuité B-

      Acuité C

      Acuité D

      Acuité D

       

    • Liquidity Back Up and Credit Enhancement Options
    •  

      A Liquidity Back-Up facility is a mechanism that allows the CP Issuer to draw funds from a pre-arranged line if they choose not to roll over the issue. Such lines constitute lines of credits from banks and other financial institutions and are factored in assigning ratings to CPs. However, no credit enhancement is extended on account of the mere presence of such facilities. The reason behind the same is the possibility of such lines not being made available by banks, in case of a steep deterioration in the credit quality of the issuer.

      CP Ratings are only enhanced by the presence of Credit Enhancement Options in the form of unconditional and irrevocable credit support facilities such as Back Stop Facilities, Guarantees by commercial banks or corporate entities. Such facilities are evaluated on three parameters:

      • The distinction between the liquidity back up and standby credit facility;
      • Whether the credit facility is irrevocable and unconditional and is available under all circumstances
      • Whether the credit enhancement would be available before the maturity date (ideally a T minus structure with sufficient buffer to ensure that in case the issuer fails to arrange the funds, the credit enhancement can come in-force before the date of maturity)

      In such cases, the rating is enhanced based on the credit risk profile of the entity providing the credit enhancement.

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