Monday, October 10, 2011

Credit Ratings – Explained

In one of our previous articles, we learnt what Credit Ratings are.

It was just an introductory article about credit ratings. In this article we are going to learn what these credit ratings are and what they are not.

What are Credit Ratings?

Credit Ratings are:
a. An Expression/Opinion about Credit Risk
b. Are provided by Rating Agencies
c. Are Continually Evolving & Forward Looking
d. Are Intended to be Comparable across different sectors and regions

Credit Ratings are not:
a. An Investment Advise
b. Assurances of Credit Quality
c. Absolute measures of Default Probability

The points may look self-explanatory. Nonetheless, let us look in detail as to what each point means.

An Expression/Opinion about Credit Risk

Credit ratings express opinions about the ability and willingness of an issuer, such as a corporation or city government, to meet its financial obligations. Credit ratings are also opinions about the credit quality of an issue, such as a bond or other debt obligation, and the relative likelihood that it may default.
Are provided by Rating Agencies

Credit Ratings are provided by Rating Agencies. There are many agencies whose sole purpose is to provide credit ratings about issues. Some of the famous ones are Standard & Poor’s, Moody’s, Fitch etc.

Are Forward Looking & Continually Evolving

Though credit ratings are arrived at based on the analysis and evaluation of historical data, rating opinions are designed to be forward looking. Simply put, ratings take into account not only the present situation but also the potential impact of future events on credit risk. For example, while assigning ratings, agencies factor in anticipated ups and downs of business cycles in specific industries as well as trends and events that can be reasonably anticipated.

At the same time, ratings are not static. Rating opinions may change if the credit quality of an issue or issuer alters in ways that were not expected at the time a rating was assigned. For example, the acquisition of a line of business, a change of policy by government, or erosion in the credit markets that was not foreseen may result in a rating adjustment that reflects this new information. The agency might choose to re-publish a revised credit rating for the affected party.

Are Intended To Be Comparable Across Different Sectors and Regions

Most rating agencies use the same rating scale across different types of companies. The rating scale is designed to provide a common language for comparing creditworthiness, regardless of the type of entity or assets underlying the debt instrument or the structure of the financial obligation.
This means that a ‘A’ rated party irrespective of whether it is a bank or a government or an automobile manufacturer carries the same level of credit risk as with other entities that have been assigned the same rating.

Are Not Investment Advise

Credit ratings are not designed to indicate the value, suitability, or merit of an investment. They are opinions of credit quality and, in some cases, the expected recovery in the event of default.

Credit ratings do not suggest whether:
• Investors should buy, sell, or hold rated securities
• A particular rated security is suitable for a particular investor or group of investors
• The expected return of a particular investment is adequate compensation for the risk it poses
• The price of a security is appropriate given its credit quality
• The market value of the security will remain stable over time

Though credit quality is an important consideration in evaluating an investment, it is not the sole criteria based on which you must base your investment decision.
Before deciding whether to invest in a particular investment option, the investor (you and me) must consider a wide range of factors like the investment strategy, time horizon, rate of returns, history of the house issuing the investment option etc. During this process the credit rating too will be considered but I repeat, we cannot and should not base our investment decision solely on the credit rating alone.

Are not Assurances of Credit Quality

Credit Ratings should not be viewed as an assurance of credit quality or the exact likelihood of default. Instead, ratings denote a relative level of credit risk that reflects a rating agency’s carefully considered and analytically informed opinion as to the creditworthiness of an issuer or the credit quality of a particular debt issue.

Are Not Absolute Measures Of Default Probability

Credit ratings are not exact measures of the probability that a certain issuer or issue will default instead, they expressions of the relative credit risk of rated issuers and debt instruments.

Most rating agencies, rank order the issuers and issues from strongest to weakest based on their relative creditworthiness and credit quality.
For example, a AAA rated issue has a higher credit quality than a BBB issue.

Similarly, if we compare the historic data, the annual average default rate of BBB rated issues was 0.30%. this does not mean that it is a prediction that, any BBB rated issue has a 0.30% default probability. It may so happen that, this year the default rate could be 0.6% or even 0.2%. in fact, the actual default rates for any specific rating category may fluctuate over time and are governed by the economic factors.

Friday, October 7, 2011

Moodys Bank Financial Strength Ratings

In the past few days there have been many news flashes about Moody's changing the Bank Financial Strength Ratings for banks in India. The most significant of which was, the downgrading of State Bank of India, the nations premier state owned banking institution from C- to D+. This caused shock waves across the stock market and the SBI shares tumbled to their 2 year low.

The purpose of this post is to understand what this Bank Financial Strength Rating is and understand the different ratings available.

What is this Bank Financial Strength Rating?

"Moody's Bank Financial Strength Ratings reflect Moody's opinion of a bank's intrinsic or stand-alone financial strength relative to all other rated banks globally."

This BFSR is a measure of the likelihood that a bank will require financial assistance in order to avoid a default.

What are the different Ratings available?

Rating Name Rating Description
A Banks rated A possess superior intrinsic financial strength. Typically, they will be institutions with highly valuable and defensible business franchises, strong financial fundamentals, and a very predictable and stable operating environment.
B Banks rated B possess strong intrinsic financial strength. Typically, they will be institutions with valuable and defensible business franchises, good financial fundamentals, and a predictable and stable operating environment.
C Banks rated C possess adequate intrinsic financial strength. Typically, they will be institutions with more limited but still valuable business franchises. These banks will display either acceptable financial fundamentals within a predictable and stable operating environment, or good financial fundamentals within a less predictable and stable operating environment.
D Banks rated D display modest intrinsic financial strength, potentially requiring some outside support at times. Such institutions may be limited by one or more of the following factors: a weak business franchise; financial fundamentals that are deficient in one or more respects; or an unpredictable and unstable operating environment.
E Banks rated E display very modest intrinsic financial strength, with a higher likelihood of periodic outside support or an eventual need for outside assistance. Such institutions may be limited by one or more of the following factors: a weak and limited business franchise; financial fundamentals that are materially deficient in one or more respects; or a highly unpredictable or unstable operating environment.

A point to note is that wherever appropriate, a "+" modifier will be appended to ratings below the "A" category and a "-" modifier
will be appended to ratings above the "E" category to distinguish those banks that fall in intermediate categories. So, a B+ is better than a B and a C- is better than a D.

This post is just the introduction about these Banking Financial Strength Ratings. Watch out for more articles on how it is calculated in future!!!

Wednesday, October 5, 2011

Retirement Planning Series - Conclusion

We have come to the end of the Retirement planning series. So far, we have covered the following:

1. Why plan for Retirement? and
2. How much money will I need?
3. Where will the money come from?
4. Building the Retirement Corpus

While it's impossible to learn everything you'll ever need to know about retirement planning in a single article, the topics we have covered in this series should give you a solid start.

Retirement planning is an ongoing, lifelong process that takes decades of commitment in order to receive the final payoff. The idea of accumulating hundreds of thousands of rupees in a retirement corpus can definitely seem intimidating, but as explained in my articles, with a few basic calculations and commitment it's not difficult to achieve.

Let's revise what we have covered so far:

• Every individual is responsible for planning for his/her retirement
• How much money you'll need to save for retirement will depend on your desired standard of living, your expenses and your target retirement age.
• To determine the size of the retirement corpus, you'll need to:
o Decide the age at which you want to retire.
o Decide the annual income you'll need for your retirement years.
o Add up the current market value of all your savings and investments.
o Determine a realistic real rate of return for your investments.
o Obtain an estimate of the value of your company pension plan.
• Assume that an annual inflation rate will erode the value of your investments and adjust your savings plan accordingly to provide yourself with a margin of safety.
• Income during retirement may come from the following sources:
o Employment income,
o Employer-sponsored retirement plans,
o Savings and investments,
o Other sources of funds, including inheritance money, prizes and lottery winnings, gifts, raises, bonuses and real estate.
• There are several investment options that can be used to achieve your retirement savings goals. These include, but are not limited to
o Bank Deposits
o Stock Market Investments
o Gold
o NSC, PPF etc
• Beginning to save for retirement at an early age is one of the biggest factors in ensuring success.
• Asset allocation is a key factor in building any successful portfolio. The assets you choose will depend on your risk tolerance and investment time horizon.
• Diversification will help you to reduce the amount of risk in your portfolio, increasing the chances that you'll reach your retirement savings goals.
• Make a household budget to ensure that you are contributing as much as possible to saving for retirement and aim to reduce unnecessary expenses

Other Considerations:

1. Remember that most investment options have tax implications
2. Make sure to factor in the amount of tax you may have to pay on the income earned through your investments (don't worry, you can find out the tax implications of the investment options in my blog in the various articles and if you cant, just leave a comment and I will get back to you)
3. Make sure to revisit your retirement plans at the end of every 2-3 years and make adjustments if required
4. Make sure you re-jig your portfolio at the end of every decade. As you progress in age, your risk capability comes down and moving from an aggressive portfolio to a conservative portfolio is a must for any individual who wants to preserve his capital around retirement age

I hope this retirement planning series was useful to you. Do leave a comment if you have any queries and I will try to answer them.

Happy Retirement Planning!!!

Retirement Planning Series - Building the Retirement Corpus

In the previous posts in the retirement series, we saw the following:
1. Why plan for Retirement? and
2. How much money will I need?
3. Where will the money come from?

The next logiccal step in the sequence would be to actually build the retirement corpus. In India, there are a myriad of investment options that are available. The most common ones are:
1. Bank Fixed Deposits
2. Stock Market Investments (Shares & Mutual Funds)
3. National Savings Certificate
4. Public Provident Fund
5. Unit Linked Insurance Plans
6. Gold
7. etc

As part of building your corpus, you are essentially building a portfolio of investments that you can use to fund your retirement. I have written multiple articles that can help you with that. They are:
1. Saving Taxes through Investments
2. What is an Investment Portfolio
3. A Conservative Portfolio
4. An Aggressive Portfolio
5. A Balanced Portfolio
6. Unit Linked Insurance Plans – De-Mystified
7. Life Stage based Portfolio

I would personally recommend that you read the last one on Life Stage based portfolio that advises on how you must plan your investments as you move on from one stage of your life to another. The stages considered are:

1. Single - Young and energetic
2. Just Married - Settling down with a new family
3. Expanding your family - Becoming a parent
4. Matured Individual - Children are grown up
5. Nearing Retirement - Old and wise

It is a good idea to begin investments early, and choose the Aggressive portfolio when you are young and move over to a balanced portfolio post marriage and when you are nearing retirement, switch over to a conservative portfolio.

Retirement Planning Series - Where will the money come from?

In the previous two posts, we saw the following:
1. Why plan for Retirement? and
2. How much money will I need?

Now that we know why to plan for retirement and how much money we need, the next logical step would be to calculate or rather figure out, where that money will come from. Isn’t it?

Where will the Money Come From?

Though employment income seems to be the most obvious answer, there are actually many sources of funds you can potentially access to build your retirement nest egg. Once you plan them all out clearly, you can then determine how much money you'll need to save every month in order to reach your retirement goals.

The typical sources of funds for retirement savings for an average individual are:

1. Employment Income

As you progress through your working life, your annual employment income will probably be the largest source of incoming funds you will receive and probably the largest component of your contributions to your retirement fund.

For your retirement plan, simply write down what your after-tax annual income is. Then subtract your annual living expenses. The amount left over represents the discretionary savings you have at your disposal.

Depending upon how the numbers work out, you may be able to save a large portion of your employment income toward your retirement, or you may only be able to save a little. Be sure to use a budget and include all your recurring expenses.

Figure out the maximum amount of your employment income that you can contribute to your retirement fund each year. Also, if you are able to work part time during your retirement years, include this information in your retirement income calculations.

For Example: Lets assume Mr. Ramesh has an after tax earnings of Rs. 5,00,000 per annum (5 lakhs). His expenses per month are around Rs. 33,000/- per month which works out to nearly 4 lakhs per year. To add on, Ramesh isn’t planning to work post retirement.

So, Mr. Ramesh has an available savings of Rs. 1 lakh every year towards his retirement plan. He can choose to invest it for retirement or take a vacation or whatever he wants. But the point here is that, if Ramesh wants, he can invest this 1 lakh every year towards his retirement corpus.

2. Employer-Sponsored Retirement Plan

This option isn’t available for a majority of us. We are all private sector employees and our employers don't usually pay us post retirement. However for people who are Government employees and have a steady pension payment post retirement, this source of income is very useful.

You should be able to calculate an estimated value (in today's rupees) of your retirement funds in terms of a monthly allowance. Obtain this number and add it to your list of retirement income sources.

For Ex: Mr. Ramesh will get a pension of Rs. 10,000 every month if he retires at his current grade of Technical Supervisor in Indian Railways. So, this 10,000 rupees is going to be a steady income for Ramesh every month after he retires.

Note: We are only considering what pension Ramesh will get if he retires at his current designation and the amount that people of his grade are getting currently. The number might vary at his actual retirement time either due to governmental policy decisions on pension or his own designation. But the point here is that, keeping this number in mind for calculation purposes will be very useful.

3. Current Savings and Investments

The next thing to consider is your current Savings and Investments. If you have a decent investment portfolio, it may be sufficient to cover your retirement needs all by itself. For more details on Investment Portfolio Click Here.

If you have yet to begin saving for your retirement or are coming into the retirement planning game only now, you will need to compensate for your lack of current savings with greater contributions in the current timeframe.

Again, going back to Mr. Ramesh as our example, let us say he has a savings/investment portfolio of Rs. 2 lakhs now at his current age of 40. Assuming a reasonable real rate of return of 6% per year until he is 65, he will have roughly 8.5 lakhs of money by the time he retires at 65 years.

Depending on other sources of income he may have, this could be enough to fund his retirement so that Ramesh does not have to contribute large amounts of his ongoing employment income.

4. Other Sources of Funds

You may have other sources that will be available to fund your retirement needs. Perhaps you will receive an inheritance from your parents before you reach retirement age or have assets, such as real estate, that you plan to sell before or after retiring.

Whatever additional sources of funds you do happen to have, be sure to include them in your retirement projections only if they are certain to be available.
You may be expecting to realize a large inheritance from your parents, but they may have other plans like leaving a larger share to your brother or donating them to charity.

Another point to note is that, you may also get some extra funds like bonuses or lottery winnings, gifts etc. Though they are not certain to happen, you need to remember to consider them for your retirement fund if they do happen.

If you do happen to get a bonus it would be a good idea to park at least 75% of the sum for your retirement corpus and avoid the impulse to spend it all out.

Next - Adding Up Your Income Sources

After you have clearly defined all the available income sources with which to fund your retirement, make a list and add them up.

Let's continue with Ramesh’s sample retirement plan. Remember, all figures are in today's dollars.

Ramesh’s retirement income sources are:

1 lakh maximum annual retirement contributions from his 5 lakh after-tax earnings.

Ramesh will get a monthly pension of Rs. 10000 post retirement from his company.

Ramesh has Rs. 2 lakhs of current savings and investments. At a reasonable 6% real rate of return for 25 years, his savings should grow to 8.5 lakhs.

Ramesh does not have any other sources of funds he can conservatively expect to add to his retirement funds. He might win the lottery, but he's not counting on it.

As mentioned in the previous chapter, Ramesh will need 40 lakhs in today’s money to fully and properly fund his retirement goals.

Since, his current investments will only provide 8.5 lakhs from his 40 lakhs of retirement corpus expected, he will need to accumulate the remaining money.

This means, he will need to save up an additional 31.5 lakhs (in today’s money) by the time he is 65 years old (which is 25 years).

To calculate this, let's track his progress over the 25-year period:

Assuming a 6% annual growth rate and constant monthly/yearly contributions, we can find that Ramesh will need to contribute Rs. 42,500/- every year to save the required corpus of 31.5 lakhs.

This works out to roughly Rs. 3500 per month for his retirement corpus.

However, let us say his parents leave him their land in their home town that is worth Rs. 10 lakhs today as Ramesh’s share of the family property, that will bring down his amount required for the corpus by an equivalent amount. If that happens, his monthly contribution towards his retirement savings will come down to Rs. 2500 per month.

Alternately, Ramesh may wish to re-think his retirement amount and bring it down to 30 lakhs which again will bring down his monthly contribution to his retirement corpus.

Nonetheless, it is the individual’s decision to decide his/her retirement amount.

The most important point while doing these calculations is to remain conservative in your financial estimates (i.e., don't assume 20% annual investment returns or hitting the lottery) and settle on a plan that is realistic, sufficient and most importantly feasible.

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