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Bond rating determinants and Bond rating

determinants
modeling: evidence from India and modeling
Sanjay Sehgal
Department of Financial Studies, University of Delhi, New Delhi, India, and
Vibhuti Vasishth and Tarunika Jain Agrawal
University of Delhi, New Delhi, India Received 8 October 2021
Revised 5 June 2022
2 September 2022
Abstract Accepted 3 September 2022
Purpose – This study attempts to identify fundamental determinants of bond ratings for non-financial and
financial firms. Further the study aims to develop a parsimonious bond rating model and compare its efficacy
across statistical and range of machine learning methods in the Indian context. The study is motivated by the
insufficiency of prior work in the Indian context.
Design/methodology/approach – The authors identify the critical determinants of non-financial and financial
firms using multinomial logistic regression. Various machine learning and statistical methods are employed to
identify the optimal bond rating prediction model. The data cover 8,346 bond issues from 2009 to 2019.
Findings – The authors find that industry concentration, sales, operating leverage, operating efficiency,
profitability, solvency, strategic ownership, age, firm size and firm value play an important role in rating non-
financial firms. Operating efficiency, profitability, strategic ownership and size are also relevant for financial
firms besides additional determinants related to the capital adequacy, asset quality, management efficiency,
earnings quality and liquidity (CAMEL) approach. The authors find that random forest outperforms logit and
other machine learning methods with an accuracy rate of 92 and 91% for non-financial and financial firms.
Practical implications – The study identifies important determinants of bond ratings for both non-financial
and financial firms. The study interalia finds that the random forest technique is the most appropriate method
for bond ratings predictions in India.
Social implications – Better bond ratings may mitigate corporate defaults.
Originality/value – Unlike prior literature, the study identifies determinants of bond ratings for both non-
financial and financial firms. The study also experiments with modern machine learning techniques besides the
traditional statistical approach for model building in case of relatively under researched market.
Keywords Bond rating, Multinomial logistic regression, Machine learning methods, CAMEL approach,
Non-financial firms, Financial firms
Paper type Research paper

1. Introduction
Credit rating is an independent process conducted by experts to evaluate credit quality by
considering different risk factors (Brusov et al., 2021). It is believed to incorporate valuable
information, evaluating various quantitative and qualitative parameters beyond publicly
available information and thus enabling the development of an efficient capital market (Tang,
2009; Lu et al., 2010). It also acts as a screening criterion and performs a monitoring role in the
financial markets, facilitating efficient resource allocation (Chong et al., 2015). Credit ratings
offer necessary information on bonds’ riskiness, making the Indian corporate bond market
more transparent (Bose and Coondoo, 2003). They also address information asymmetries,
especially in the micro, small and medium enterprises (MSME) sector (Shankar, 2019). Bond
ratings assume importance as the Indian corporate bond market is nascent. The corporate
debt to GDP ratio is significantly lower at 17.16% compared to the average in other
developing countries (Ganguly, 2019).

JEL Classification — C53, G21, G23, G24, C38, G3

This work was supported by the Ministry of Corporate Affairs, Government of India. Managerial Finance
The authors thank Mr. Kausik Sen for providing technical guidance and support with machine © Emerald Publishing Limited
0307-4358
learning models. DOI 10.1108/MF-10-2021-0489
MF One of the primary considerations for correct ratings of bonds requires an explicit
acknowledgment of the inherent differences between non-financial and financial firms.
These firms differ regarding their nature of operations, regulatory framework and
financial statement characteristics, owing to the nature of their assets and liabilities. The
presence of high financial leverage and low degree of operating leverage (DOL), which is
unique to financial firms, makes it difficult for a common standard list of determinants to
predict the riskiness of both non-financial and financial firms. Differences in asset and
liability mix result in distinct factors playing a more critical role in a financial firm’s bond
ratings. For instance, interest rates significantly impact financial firms’ valuations,
whereas firm size and value play a more prominent role in non-financial firms (See Foerster
and Sapp, 2005).
Moody’s Investors Service, Standard & Poor’s (S&P) Global Ratings and Fitch Ratings
control almost 95% of the rating business globally (European Securities Market Authority,
2019). The Indian credit rating agencies (CRA) profiles are similar to their global
counterparts. It is often perceived as generous when assigning ratings (National Institute
of Securities Markets, 2009). CRISIL, ICRA and CARE dominate the Indian rating industry,
which otherwise includes seven rating agencies [1]. However, catastrophic rating failures [2],
like during the Global Financial Crisis 2008–09, sudden default of highly rated securities, and
the NBFC liquidity crisis in India, from 2018 onwards, have discredited the present bond
rating process.
In light of these shocks, the “black box” credit rating methodologies’ efficacy is
questioned (Brusov et al., 2021). How objective is the credit rating process? What are the
true determinants of credit rating? Are the determinants common across non-financial and
financial firms? Can publicly available data be used to predict ratings? Is it possible to
achieve greater rating accuracy by employing more recent machine learning methods
instead of traditional statistical models? In this study, we seek answers to these questions
and contribute to the existing literature. We find that different factors contribute to the
credit risk assessment for non-financial and financial firms. For non-financial firms,
important determinants for bond ratings include industry concentration, level of
operations, operating leverage, operating efficiency, profitability, solvency, level of
strategic ownership, firm age and market characteristics such as size and value. We find
some of these determinants to be common for financial firms also. We find a significant
impact of operating efficiency, profitability, level of strategic ownership and firm size on
bond ratings.
Additionally, we find six significant determinants from the CAMEL framework [3], i.e.
capital adequacy, operating expenses to total expenses, government vs. private ownership,
the cost to income, growth in interest income and liquid assets to total assets. Our findings
indicate that financial firms’ rating process emphasizes the profitability of assets rather than
maintaining a safe cushion with liquid assets. Also, we find that the asset quality of financial
firms does not significantly impact ratings. We do not find the role of bond characteristics in
the rating process of non-financial and financial firms, implying that CRAs mix bond ratings
with issuer ratings. Our predictive models provide high accuracy rates. However, in light of
recent failures of CRAs in predicting defaults, we suggest they can further improve their
rating processes. Specifically, rating agencies should place a higher emphasis on the asset
quality and safety of financial firms. At the same time, they must distinguish between the
issuer and issue-specific ratings for all kinds of firms. We provide confirmatory evidence that
random forest has a competitive edge over other machine learning methods and the
conventional statistical model for predicting bond ratings. Hence, CRAs should use this
method in rating non-financial and financial firms.
A sound credit rating framework is critical for demonstrating the creditworthiness of the
corporates to domestic and foreign investors (Berkley, 2019). Two essential elements in any
credit rating framework are rating determinants and the techniques used for forecasting Bond rating
ratings. There exist a plethora of determinants for bond rating, incorporating various aspects determinants
of the industry and business risk factors as well as the operational and financial performance
of a company (See Horrigan, 1966; Pogue and Soldofsky, 1969; Pinches and Mingo, 1973;
and modeling
Kaplan and Urwitz, 1979; Adams et al., 2003; Gray et al., 2006; Hwang et al., 2010; Hajek and
Michalak, 2013; Feki and Khoufi, 2015; Jiang and Packer, 2019; Yang et al., 2020). Few studies
have highlighted the role of qualitative factors (management quality and efficiency, corporate
governance, and so forth) in influencing and improving credit rating (Grunert et al., 2005;
Khemakhem and Boujelbene, 2018; Bhattacharya and Sharma, 2019).
Although the determinants of credit rating have been studied extensively, empirical
studies have only focused on developed economies. The evidence from an emerging economy
like India is very limited in number and scope. In the Indian context, Bhattacharya and
Sharma (2019) ascertain the impact of environment, social and governance (ESG) disclosures
on credit ratings using ordered logistic regression. Mamilla et al. (2019) studied the impact of
certain economic variables on credit rating. Bandyopadhyay (2019) discusses the accuracy of
the Indian CRAs. Shankar (2019) examines the possible role of CRA in the context of MSMEs,
and Krishnan et al. (2019) study the market reaction to rating changes under enhanced
transparency norms.
Identifying fundamental determinants would help reduce the time spent collecting and
analyzing data and thus reduce the cost and increase efficiency (Yang et al., 2020). We draw
our prime motivation from the lack of comprehensive research on the subject in the Indian
context. Our first objective is to identify the fundamental rating determinants for non-
financial firms. We examine the role of industry characteristics, firm-level operating,
financial, market and managerial factors, and bond characteristics in the rating
determination process.
The financial sector relies heavily on credit rating for risk measurement and management
[4] and regulatory purposes (Gama and Geraldes, 2012). Financial institutions use ratings to
assess the probability of default of their corporate borrowers (Treacy and Carey, 2000) and
the riskiness of their investment portfolio. A deterioration in the rating of the asset portfolio
(including exposure to both non-financial and financial companies) hurts the bank’s rating.
Financial institutions play a central role in the financial crisis. Hence, their erroneous rating
judgments severely affect the entire financial system. Despite such dependency, the number
of studies analyzing the ratings in the context of the financial sector is limited. Adams et al.
(2003) study the United Kingdom Insurance Industry; Grunert et al. (2005) examine German
banks, and Hau et al. (2013) focus on European and American bank ratings. The recent work
of Golbayani et al. (2020) and Yang et al. (2020) draws a comparison between the US financial
sector with other sectors such as energy, consumer discretionary, and healthcare. Foerster
and Sapp (2005) note that excluding financial firms from the empirical analysis influences the
outcome and the corresponding implications. This problem is amplified in the Indian context
primarily for two reasons. First, India’s financial sector contributes to economic growth more
than developed economies. The weightage of the financial sector in the Indian broad-based
index – NSE 200, is 35.64%, which is over three times more than 11.20% in the S&P 500, a
broad-based index of the USA.
Further, the problem of severe non-performing assets (NPA) has plagued the Indian
financial sector, especially in the last decade [5]. This situation may result from the bank’s
internal credit risk analysis dependency on external ratings, which leads to underestimating
risk, making the financial institutions more vulnerable.
Empirical studies analyzing the determinants of the ratings for financial firms in the
Indian environment are virtually absent. Moreover, the determinants of bond ratings are not
simply transferable from non-financial to financial firms, owing to the increased leverage.
Given that most of the rated cases in India relate to financial firms (almost 2/3rd of our
MF dataset), we attempt to analyze which determinants are common for non-financial and
financial firms and what additional factors are required for bond rating prediction in the case
of financial firms.
Based on this premise, identifying fundamental determinants for financial firms becomes
our second objective. Considering the regulatory framework and accounting convention
differences, we augment the existing list of factors by assimilating information on the
relevant ratios based on the CAMEL approach.
Most prior work on ratings employs standard statistical techniques such as logistic
regression analysis and multiple discriminant analysis (Altman, 1968; Altman et al., 1977;
Pinches and Mingo, 1973; Kaplan and Urwitz, 1979; Ederington, 1985; Abdou et al., 2016).
Studies also use modified versions of traditional statistical techniques [6] to predict ratings
(Gogas et al., 2014; Karminsky and Khromova, 2016). The statistical methods used have wide
applications in the financial area, particularly for identifying factor structure (Khemakhem
and Boujelb
ene (2015). However, different assumptions (such as linearity, normality and
distribution-dependency) made behind such approaches limit their predictive capability
compared to machine learning techniques. The recent emergence of machine learning and
artificial intelligence techniques opens new avenues for developing improved credit risk
assessment methods (Huang, 2009). These techniques consist of decision trees, including the
random forest method (Huang et al., 2004; Paleologo et al., 2010; Wallis et al., 2019; Golbayani
et al., 2020; Wang et al., 2020) and gradient boosting machine (Tian et al., 2020; Wu et al., 2022);
support vector machine (Lee, 2007; Danenas and Garsva, 2015) artificial neural networks
(Angelini et al., 2008; Yu et al., 2008) and Naı€ve Bayes (Li et al., 2006; Wang and Ku, 2021).
Several studies (Huang et al., 2004; Golbayani et al., 2020; Wang and Ku, 2021) compare the
efficacy of machine learning models. Besides, some papers (Khemakhem and Boujelb
ene, 2015;
Wallis et al., 2019; Wang et al., 2020) compare the performance of machine learning and
artificial intelligence models to the traditional statistical models in predicting credit ratings.
Inadequate investigation using machine learning methods leaves a vital research gap in
India’s literature on credit rating. Our third motivation to conduct this study emanates from
this lack of empirical evidence. To fill this research gap, we attempt to develop a
parsimonious bond rating model based on critical determinants and compare their efficacy
across statistical and machine learning methods. As a standard practice, accuracy rates are
compared across the models to identify the best-performing model. However, it is crucial to
investigate the degree of accuracy of the rating prediction model. Following Golbayani et al.
(2020), we calculate rating misclassification distance to quantify the difference between
predicted and actual ratings. Further, we calculate the dissimilarity coefficient, which offers
new insights into the performance of different bond rating prediction models in the Indian
context.
The paper is organized as follows. In the second section, we describe the data and
variables used in the study. Section 3 contains the methodology adopted for factor selection
and rating model development. Empirical results are discussed in section 4, while conclusions
are drawn in the last section.

2. Data and variable description

This section describes the data used for corporate bond ratings and their fundamental
determinants. We select 2009 as the starting point of study to eliminate the impact of the
global financial crisis on our results (see Ahmad et al., 2013). We classify the sample data into
non-financial and financial firms based on the global industry classification standard (GICS),
Thomson Reuters. Our sample spans various industries and sectors, making it adequate to
conduct a comprehensive comparative evaluation between non-financial and financial firms
and account for the regulatory framework and accounting convention differences.
 First, we define the dependent variable for our empirical analysis. We initially started with Bond rating
14,693 issues of long-term corporate bonds rated by CRISIL, ICRA and CARE from 2009 to determinants
2019. There are eight broad rating classes, ranging from AAA to D. Most observations are
rated at AAA (36.77%) or AA (41.37%). Very few observations are rated at lower ratings,
and modeling
such as BBB and below (7.81%). In this study, we merge the ratings BBB and below due to
limited observations in the tails [7]. Table 1 shows the frequency distribution of codified
rating classes – 1,2,3 and 4 corresponding to the AAA, AA, A and BBB and below rating
classes. AAA and AA account for more than 75% of the long-term ratings, indicating a
disconnect between the actual and the assessed credit risk in light of the heightened financial
distress in the economy and severe NPA issues in the banking sector.
Next, we describe the process adopted for identifying the fundamental determinants of
bond ratings in India. In India, it may be noted that the financial year spans from April to
March. Thus, each year we work with financial data available as of March-end, the financial
closing month. As suggested by prior international work, the rating prediction should be
based on financial data three months before the rating release (See Huang et al., 2004; Cao
et al., 2006). Hence, we consider the rating assigned to bond issues in June each year [8]. The
number of issues considered in our sample varies yearly. The annual data obtained is pooled,
which we use for all other estimations. For computing various financial variables, we require
data on annual financial statements of the last three years prior to rating release.
Accordingly, we take the consolidated dataset’s annual financial data from 2006 to 2019.
Previous studies have considered a range of potential determinants for analyzing bond
ratings. Some studies, for instance, Mamilla et al. (2019), study the impact of certain economic
variables on credit rating. However, the omission of macroeconomic variables, which do not
vary cross-sectionally, would not impact the ranking of the estimation methods and hence are
not considered in the analysis.
We initially identified 70 explanatory variables for all firms in the present study based on
prior literature, the rating framework of international and national CRAs, and financial
theory. Further, 29 additional variables are extracted only for financial firms. The 70
variables identified span six attributes: Industry Characteristics, Business Characteristics,
Financial Characteristics, Managerial Characteristics representing Management Quality,
Market Characteristics and Bond Characteristics [9].
However, minimal data is available for most of these variables across sample cases over
the study period. Hence, we finally use 16 variables covering these categories for which the
data is available for at least 2/3rd of the cases. The final dataset comprises 8,346 cases, of
which 2,934 and 5,412 issues correspond to non-financial and financial firms. Table 2 entails a
detailed description of these 16 variables corresponding to each category.
Industry concentration is measured using Herfindahl-Hirschman Index (HHI) (See Gray
et al., 2006). To evaluate the impact of business characteristics, we use four determinants,

Category 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

1 103 153 175 228 245 280 322 329 395 432 407
2 95 131 168 202 290 321 367 420 464 512 483
3 24 38 52 60 58 69 97 130 183 216 245
4 6 29 34 44 56 55 58 80 96 104 90
Total 228 351 429 534 649 725 844 959 1,138 1,264 1,225 Table 1.
Note(s): Indian CRAs provide ratings across eight broad rating classes ranging from AAA to D. Due to the Distribution of bond
lack of data in the lower rating categories, we merge all classes into four groups - AAA, AA, A, BBB, and below. rating categories from
These are represented by categories 1, 2, 3, and 4. This table shows the number of issues rated in each category 2009 to 2019 for the
from 2009 to 2019 Indian market
MF Attributes Determinants Measure Abbreviation

Industry characteristics Industry Herfindahl- Hirschman Index. (For HHI

concentration computing HHI, we classify firms into
10 different sectors based on global
industry classification standard
(GICS), available on Thomson
Reuters. For each sector, the top 10
firms are identified based on the
revenue in a particular year. We
compute their market share as the
firm’s revenue divided by the
aggregate revenue for a sector in a
particular year. HHI for each sector
each year is computed by summing
the square of the top 10 firms’ market
share.)
Business characteristics Level of Total Sales TS
operations
Competitive Sales as a percentage of total S/IS
position industrial sales
Operating Operating expenses to sales ratio (For OE/S
efficiency non-financial firms)
Interest cost to sales ratio (For IC/S
financial firms)
Degree of Percentage change in EBIT to DOL
operating percentage change in sales
leverage
Financial characteristics Profitability Return on assets ROA
Sales growth Growth in sales on a year-on-year SG
basis
Activity Asset turnover ratio AT
Structure Long term borrowings to total LT/TB
borrowings ratio
Solvency Equity to total assets ratio E/A
Coverage Interest coverage ratio ICR
Managerial Ownership Strategic ownership SO
characteristics Reputation and Age of the firm. (We take a natural log AGE
representing management experience of the number of years of a firm’s
quality existence.)
Market characteristics Size Natural log of market capitalization MC
Valuation Natural log of price-to-Book value P/B
ratio
Bond characteristics Subordination I Included as a dummy variable with a SUB
status value
1 for an unsecured bond and 0 for a
secured bond because the former is
subordinate to the latter in the
Table 2. hypothecation process
Description of bond Note(s): This table mentions all significant attributes, their determinants, and measures used for modeling
rating determinants bond ratings of non-financial and financial firms. We also mention the abbreviation used for each measure

i.e. level of operations (measured using total sales); competitive position (measured using sales
as a % of total industrial sales); operating efficiency (measured using operating expenses to
sales ratio); and degree of operating leverage (measured using percentage change in EBIT to
percentage change in sales) (See Kim and Ahn, 2012; Balios et al., 2016). To estimate the impact
of financial characteristics, we consider six determinants: profitability, sales growth, activity, Bond rating
structure, solvency and coverage. Return on assets (ROA) measures profitability; year-on-year determinants
growth in sales incorporates the growth aspect; the asset turnover ratio is included as an
activity ratio. We use long-term borrowing to total borrowing as a structure ratio, equity to
and modeling
total assets ratio as a measure of solvency, and interest coverage ratio to measure coverage
(Horrigan, 1966; Belkaoui, 1980; Ederington, 1985; Kamstra et al., 2001; Touray, 2004;
Brabazon and O’Neil, 2006; Bellovary et al., 2007; Doumpos et al., 2015; Feki and Khoufi, 2015).
Managerial characteristics represent management quality and are determined using
ownership (measured using strategic ownership as an essential measure of control);
reputation and experience, measured through the firm’s age (See Yazdi et al., 2019; Czarnitzki
and Kraft, 2007). Market characteristics are determined using size and valuation. To evaluate
the performance of stocks, we use market capitalization to measure the size and gain a sense of
relative valuation as viewed by the market; we use the price-to-book value ratio (See Belkaoui,
1980; Ederington, 1985; Chaveesuk et al., 1999; Kamstra et al., 2001; Touray, 2004; Brabazon
and O’Neil, 2006; Hwang et al., 2010; Kors et al., 2012; Hwang, 2013; Doumpos et al., 2015).
Finally, bond characteristics are measured using the bond subordination status, which has
implications for collaterals in the event of winding up (See Horrigan, 1966).
We use all these variables for modeling rating prediction of non-financial and financial
firms, except the interest cost to sales ratio, which we use in place of operating expenses to
sales ratio in the case of the latter data set. In the case of financial firms, we do not have data for
operating expenses to sales ratio for about 55% of the cases. Moreover, interest cost is a
significant component of operating expenses for financial firms. We have its data for at least 2/
3rd of the cases, which is the cut-off we have considered for selecting other financial variables.
We compile 29 additional factors for financial firms based on the popularly used CAMEL
criterion encompassing five attributes – capital adequacy, asset quality, management
efficiency, earnings quality and liquidity (See Gambetta et al., 2019; Forgione and Migliardo,
2018; Chodnicka-Jaworska and Jaworski, 2017; Kocenda and Iwasaki, 2020; Bersch et al.,
2020) [10]. We finally consider only nine variables by applying the same filter rule mentioned
above. Table 3 provides their detailed description. Total equity (measured by net worth)

Attribute Determinants Measure Abbreviation

Capital adequacy Total equity Net worth NW

Asset quality Level of non- Net NPA to Net Worth NNPA/NW
performing assets
Extent of Provision coverage ratio PCR
provisioning
Management Cost structure Operating expenses to total expenses ratio OE/TE
efficiency Profitability growth Growth in profit after tax on a year-on-year basis PG
Ownership Government vs. private ownership. (We include a OS
structure dummy variable to account for the ownership
structure, taking a value of 1 for government-
owned and 0 for privately-owned financial
institutions.)
Earnings quality Cost efficiency Cost-to-income ratio C/I
Revenue efficiency Growth in interest income on a year-on-year IG
Table 3.
basis Description of
Liquidity Short term liquidity Liquid assets to total assets ratio LA/TA additional bond rating
Note(s): This table describes all additional attributes, their determinants, and measures based on the determinants for
popularly used CAMEL approach for modeling bond ratings of financial firms. We also mention the financial firms based
abbreviation used for each measure on CAMEL approach
MF determines capital adequacy. We select two determinants of asset quality – The level of non-
performing assets (measured by net NPA to net worth) and the extent of provisioning
(measured by provision coverage ratio). We include three determinants of management
efficiency – cost structure (measured with operating expenses to total expenses ratio),
profitability growth (measured with year-on-year growth in profit after tax, and ownership
structure (government vs. private ownership represented with a dummy variable). We
determine earnings quality by cost efficiency (measured with cost to income ratio) and
revenue efficiency (measured with year-on-year growth in interest income). Lastly, short-term
liquidity (measured with the liquid assets to total assets ratio) represents liquidity.
We take data for all the variables except those representing bond characteristics from
Thomson Reuters Eikon database. We extract information on the subordination status of
bonds from the databases of respective CRAs.

3. Methodology
Literature on credit rating prediction has employed two estimation approaches – traditional
statistical methods and machine learning techniques. The studies using traditional statistical
techniques make estimations using logistic regression, probit model and linear discriminant
analysis (See Steenackers and Goovaerts, 1989; Stepanova and Thomas, 2001; Kumar and
Bhattacharya, 2006; Gray et al., 2006; Khemakhem and Boujelbene, 2015; Bhattacharya and
Sharma, 2019). Since our dataset deals with more than two categories and involves natural
ordering, we made initial estimations using multinomial as well as ordered logit models.
However, we find a higher accuracy rate for the former and thus proceed with that method.
The coefficients in the multinomial logistic model explain the relationship probability
between one rating class relative to the baseline category. In our multinomial logistic model,
estimated for the total period, Category 4 represents the lowest-rated issues, considered the
base category. The standard interpretation is that for a unit change in the predictor variable
(independent variable), the outcome relative to the referent group (dependent variable) is
expected to change by its respective parameter estimate (which is in log-odds units); other
variables held constant. A positive coefficient highlights a positive relationship between the
determinants and bond ratings.
The starting point of our empirical analysis is the estimation of credit rating for non-
financial firms (a total of 2,934 cases), which considers all 16 variables mentioned in Table 2.
By performing multinomial logistic regression, we identify that 10 out of 16 factors
significantly affect bond ratings (using a 5% significance level). Henceforth, we only consider
these factors for further investigation. We verify any linear dependencies between these
factors by estimating the cross-correlation matrix. We do not find any of the two factors
highly correlated, as all correlation values are less than 0.6 [11].
The chosen variables represent all broad categories except bond characteristics. The final
model includes the Herfindahl-Hirschman Index as a measure of industry characteristics;
total sales, operating expenses to sales and degree of operating leverage as measures of
business characteristics; return on assets and equity to total assets as measures of financial
characteristics; age and strategic ownership as management quality measures; and market
capitalization and price to book ratio as measures of market characteristics. This process
helps us identify a parsimonious model that now includes only the most critical regressors
from each category and has a relatively high explanatory power.
Next, we conduct a separate analysis with the same set of 16 variables on financial firms to
verify if their role varies from what was observed for non-financial firms. It is possible that
some of these variables may or may not be significant or even exhibit a different direction in a
relationship which we attempt to explain. For this sample set comprising 5,412 cases, we
identify eight out of 16 factors that are significant at a 5% level using multinomial logistic
regression. These factors are representative of only four of the broad categories mentioned Bond rating
above. This model includes interest cost to sales as a measure of business characteristics determinants
(used instead of operating expenses to sales); return on assets, asset turnover, equity to total
assets and long-term borrowing to total borrowing as measures of financial risk; strategic
and modeling
ownership as a measure of management quality; and market capitalization and price to book
ratio as measures of firm characteristics.
We augment this eight-variable model with nine additional variables using the CAMEL
criterion. Re-applying multinomial logistic regression on this sample set provides us with 10
out of 17 factors that are significant at a 5% level. It retains interest cost to sales, return on
assets, strategic ownership and market capitalization from the previous model. The
additional factors included are net worth (representing capital adequacy), operating expenses
to total expenses, and government vs. private ownership (proxying for management
efficiency); cost to income and growth in interest income (measuring earnings quality); and
liquid assets to total assets (representing liquidity). We again verify any multi-collinearity
issues relating to these factors by estimating the cross-correlation matrix. Using 0.6 as the
cut-off level, we do not find any of the two factors highly correlated.
Separate rating prediction models are estimated for non-financial and financial firms to
capture their unique operating, financial and risk characteristics.
After identifying the critical determinants of non-financial and financial firms using
multinomial logistic regression (Khemakhem and Boujelb
ene, 2015), we reconfirm the role of
these factors in predicting bond rating using the random forest (RF) method (See Mori and
Umezawa, 2007; Ryser and Denzler, 2009; Yeh et al., 2012; Hajek and Michalak, 2013;
Veronezi, 2016; Addo et al., 2018; Wallis et al., 2019; Moscatelli et al., 2019; Wang and Ku,
2021). The random forest method provides the ranking of the variables based on their
importance and estimates which variables are significant in the classification taking into
account the interaction between variables (Wang et al., 2020). MeanDecreaseAccuracy gives a
rough estimate of the loss in prediction performance when that particular variable is omitted
from the training set. On the other hand, MeanDecreaseGini measures the importance of that
specific variable for correct classification. GINI is a measure of node impurity. The highest
purity means that each node has only elements of a single class. Assessing the decrease in
GINI when that feature is omitted leads to understanding how important that feature is to
split the data correctly. Variables are ranked in terms of their importance using these
measures, disregarding their absolute values.
While evaluating various bond rating prediction models (machine learning and statistical
methods), we identify the optimal model with the highest prediction accuracy in the Indian
context. Several dynamic models are mentioned in the recent work (See Mizen and Tsoukas, 2012;
Reusens and Croux, 2017; Dimitrakopoulos and Kolossiatis, 2016; Tuzcuoglu, 2022). However, we
limit our focus to static statistical and machine learning models in the present study.
We consider the following machine learning models – RF, gradient boosting machine
(GBM), support vector machine (SVM), multi-layer perceptron artificial neural networks (ANN-
MLP), and Naı€ve Bayes (NB) for credit rating prediction along with the multinomial logistic and
ordered logistic model, a popular statistical approach. We use the same dataset across the
models to compare the performance of the rating models on the same footing with the pre-
specified factor structure. The multinomial and ordered logit models discussed above are re-
estimated using the 2/3rd – 1/3rd bifurcation, where 2/3rd of the data is used to train the model
resultant model tested on the remaining 1/3rd of the data to draw a meaningful comparison. We
follow a similar bifurcation between the training and test data for machine learning-based
estimations. We also use five-fold cross-validation as a robustness check, whereby we create
five different models on five different test sets, generating more reliable forecasts.
Breiman (2001) offers a detailed discussion on RF. Our analysis takes T, the number of
randomly sampled variables as candidates at each node equal to one thousand. n, the number
MF of trees in the forest is 2 in the model, given the achieved optimality of the model. Recent
studies have evaluated the GBM for credit risk assessment and found its performance
superior to other methods (See Tian et al. 2020; Wu et al. 2022). The hyperparameters used for
our model are as follows – The number of trees is 50, and the maximum depth of a tree is 5.
The minimum rows, i.e. the fewest allowed observations in a leaf, are set at a default value of
10. The learning rate for our model is set at 0.1, indicating the speed at which our model learns.
Many previous studies (Huang et al., 2004; Cao et al., 2006; Lee, 2007; Ye et al., 2008; Yu
et al., 2008; Kim and Sohn, 2010; Hajek and Olej, 2011, 2014; Kim and Ahn, 2012; Yeh et al.,
2012; Pai et al., 2015; Wallis et al., 2019) have examined the SVM prediction rates with other
machine learning techniques in the credit rating process. Our model was optimal with a
penalty parameter of 5. The kernel trick is an efficient algorithm that introduces additional
features in the given space. We use a radial basis kernel function in a one versus all approach.
ANN is another popular machine learning technique adopted in the corporate credit rating
assessment application. West (2000) and Baesens et al. (2003) investigate the performance of the
ANN model in credit rating and show that the ANN model performs better than the traditional
statistical methods. Several studies (Garavaglia, 1991; Moody and Utans, 1994; Huang et al.,
2004; Kim, 2005; Brabazon and O’Neill, 2006; Cao et al., 2006; Lee, 2007; Yu et al., 2008; Khashman,
2010; Kim and Sohn, 2010; Hajek, 2012; Hajek and Olej, 2014; Khemakhem and Boujelbene, 2015;
Zhao et al., 2015; Addo et al., 2018; Caridad et al., 2019; Wallis et al., 2019) have analyzed the
efficacy of ANN in credit rating models. ANN models the way information flows and decision-
making happens in the nervous system. For our ANN – MLP (multi-layer perceptron) analysis,
we use 50 neurons with ten hidden layers to mimic human decision-making.
Based on the Bayesian theorem, NB is used as a classifier technique with the “naive”
assumption of conditional independence, generally incorrect in real-world situations. Wang
et al. (2020) compare the credit risk model using the NB Model, logistic regression analysis,
RF, decision tree and K-nearest neighbor classifier. Hajek et al. (2016) used the NB network to
forecast corporate credit ratings. Our model uses the laplace smoothing parameter as five and
the number of folds for cross-validation as 10 to address overfitting and obtain a more
accurate result.
Typically, standard accuracy rates, the percentage of cases correctly classified in the test
data, are compared to evaluate the efficacy of the credit rating models (Golbayani et al., 2020).
However, the accuracy rate does not offer insights into the model’s degree of accuracy/
inaccuracy. Thus, we measure the degree of accuracy/inaccuracy by computing rating
misclassification distance (RMD), dissimilarity coefficient (DC) and absolute dissimilarity
coefficient (ADC). We calculate the distance between the predicted and actual rating classes in
numerical terms. For example, if the actual rating is AAA and the predicted rating is A, the
RMD is 3–1 5 2. i.e. predicted minus the actual. Thus, RMD, N, can take value, i 5
3 to þ3 in
our analysis. When the model prediction is accurate, variable i would be 0. Further, we
calculate the frequency of the rating misclassification, F(i), by dividing the number of
observations corresponding to the rating misclassification by the total number of
observations. Using the following equation, we compute DC, representing the expected
RMD concerning the specific model.
X
DC ¼ E½N ¼ i i * FðiÞ (1)

where i is the rating misclassification, F(i) depicts the frequency corresponding to each i.
Similarly, we define ADC as,
X
ADC ¼ E ½jNj ¼ i jij * FðiÞ (2)
where jij is the absolute value of the rating misclassification, F(i) depicts its corresponding Bond rating
frequency. The standard deviation of the variable N typically indicates how far the model’s determinants
predicted rating is from the actual rating. We calculate the variance based on Jensen’s
Inequality [12], using the following equation
and modeling

VAR ðNÞ ¼ σ 2 ¼ ½N2
ðE½NÞ2 ≥ 0 (3)

In the next section, we provide the empirical results.

4. Results and discussion

This section is divided into two phases, wherein we analyze the fundamental credit rating
determinants for non-financial and financial firms in the first phase. In the second phase, we
focus on model building.

4.1 Fundamental determinants of bond ratings

For non-financial firms, we initially begin the analysis by applying multinomial and ordered
logistic regression on 16 variables. The models give an accuracy rate of 75.36 and 71.58%,
representing the ratio of correctly classified cases to the total number of cases. Since the
multinomial logistic model provides a higher accuracy rate, we proceed with it for further
analysis.
We identify ten factors that significantly impact bond ratings. These factors represent all
major attributes except bond characteristics (See Table 4-A). We compare the best-rated
bonds (category 1) with the base category (4) to identify factors based on significance level
and analyze the relationship’s direction. However, Table 4-A also reports the results of
categories 2 and 3.
For model building in the case of non-financial firms, we proceed with these ten factors.
Their cross-correlation matrix is shown in Table 4-B. We do not observe any two variables to
be highly correlated.
Our results show a positive impact of industry concentration on assigned credit ratings.
The findings align with prior work (See Gray et al., 2006). It could be due to the benefit of
monopolistic power and price control offered by industry concentration to larger firms, and
most of the firms in our sample happen to be large-cap firms. While analyzing business
characteristics, we find that level of operations (measured using total sales), degree of
operating leverage and operating efficiency (measured using operating expenses to sales)
positively impact bond ratings, consistent with theory. We expect firms with higher sales to
have greater dominance.
Further, a higher degree of operating leverage proves advantageous to firms with rising
sales levels, resulting in improved operating profits. We find better ratings when the
operating expense to sales ratio is lower, implying a positive relationship between operating
efficiency and bond ratings. Prior work demonstrates that total revenue positively impacts
credit ratings (See Feki and Khoufi, 2015). Also, operating efficiency provides valuable
information in credit rating predictions (See Chi et al., 2011). However, our findings regarding
the relationship between operating leverage and credit ratings are contradictory to that in
prior work (See Ayres and Blank, 2017).
Profitability (measured by ROA) and solvency (measured by Equity to Total Assets) have
a significant positive impact on bond ratings, reflecting the importance of financial
characteristics. These results match the expected outcome. Firms with higher profitability
and better solvency (implying lower risk) are expected to have better ratings. Our findings are
also in consensus with prior work (See, Feki and Khoufi, 2015; Doumpos et al., 2015; Balios
et al., 2016). We find a significant impact of management quality on credit ratings. We observe
MF Category 1 Category 2 Category 3
p p p
Variable Coefficient Value Coefficient Value Coefficient Value

Panel A: Bond rating determinants

HHI 0.0037 0.0000 0.0002 0.4310
0.0011 0.0000
TS 0.0003 0.0000 0.0003 0.0000 0.0001 0.4260
S/IS 0.6314 0.1050 0.0691 0.8570
0.1236 0.7860
OE/S
4.3544 0.0000 0.4092 0.5110
0.5491 0.3710
DOL 0.0011 0.0000 0.0003 0.2830
0.0013 0.1370
ROA 8.2732 0.0330 9.6338 0.0000 4.0371 0.0830
SG 0.0021 0.5850 0.0030 0.0870 0.0019 0.2120
AT
0.3969 0.1550
0.2856 0.1140 0.2129 0.1990
LT/TB 1.1122 0.0630 1.7677 0.0000 0.1616 0.5720
E/A 10.5788 0.0000 4.5549 0.0000 3.8238 0.0000
ICR 0.0125 0.1710 0.0125 0.1700 0.0094 0.2940
SO
0.02155 0.006
0.0207 0.0000
0.0210 0.0000
AGE 2.7125 0.0000 1.3609 0.0000 0.5399 0.0000
MC 2.2158 0.0000 0.7644 0.0000 0.3332 0.0000
P/B 0.9369 0.0000 0.9763 0.0000 0.5293 0.0000
SUB
9.7621 0.9920
11.0371 0.9910 2.2963 0.9990
CONSTANT
18.7371 0.9840 0.4451 1.0000
4.9701 0.9980

HHI TS OE/S DOL ROA E/A SO AGE MC P/B

Panel B: Cross-correlation matrix between 10 statistically significant determinants

HHI 1.0000
TS 0.3835 1.0000
OE/S
0.2284 0.0073 1.0000
DOL 0.0091
0.0011 0.0169 1.0000
ROA 0.1089 0.0850
0.3895
0.0242 1.0000
E/A 0.0768
0.0383
0.0148
0.0184 0.5530 1.0000
SO 0.0737
0.0359
0.0177 0.0178 0.0029 0.1349 1.0000
AGE 0.0881 0.1710 0.0744
0.0005 0.0372 0.0368
0.2819 1.0000
MC 0.3668 0.5209
0.2236 0.0040 0.2675 0.0567
0.0813 0.0038 1.0000
P/B 0.0100 0.0278
0.0389 0.0296 0.2781
0.0105
0.0143
0.1412 0.3502 1.0000
Note(s): We work with 16 major determinants of bond ratings for non-financial firms. We find ten variables
Table 4. significant at the 5% level out of these. Panel A shows the results for categories 1, 2 and 3 to the base category
Fundamental four. However, to identify factors based on significance level and analyze the direction of the relationship, we
determinants of bond compare only the best-rated bonds (category 1) with the base category. Panel B reports the cross-correlation
ratings for non- matrix of 10 significant variables identified. We do not find any two variables to be highly correlated. The
financial firms abbreviations used in the table are the ones mentioned in Table 2

a negative relation between strategic ownership and credit ratings. Investors do not prefer the
concentration of stake in the hands of a few [13]. Prior work provides mixed evidence on the
relationship between ownership structure and credit quality (See Jensen, 1993; Bhojraj and
Sengupta, 2003; Cornett et al., 2006). On the other hand, a positive relationship is observed
between age and ratings, as older firms that are more experienced and resilient are expected
to have lesser default rates, which is in line with prior work (See Czarnitzki and Kraft, 2007).
We find a positive association between bond ratings and market characteristics, such as size
and value. Large-sized firms are expected to have lesser credit risk leading to better ratings.
(See Doumpos et al., 2015). Firms with higher P/B ratios are assigned better ratings, showing a
preference for fundamentally strong and growth-oriented firms. Prior work also suggests
that rating methodology in developed markets prefers market value ratios (See Hajek and
Michalak, 2013).
 Our empirical work highlights all attributes as significant, except for bond characteristics. Bond rating
Our findings imply that CRAs in India do not seem to differentiate bond ratings from determinants
corporate ratings. On analyzing the determinants, we find that their focus is on rating the
issuer, though they are rating specific issues. However, past studies report a significant role
and modeling
of the bond subordination status in determining the assigned credit ratings in developed
markets (See Horrigan, 1966; Pinches and Mingo, 1973; Kaplan and Urwitz, 1979).
We next focus on identifying key bond rating determinants for financial firms. We initially
run multinomial logistic regression on the previously mentioned16 variables used for non-
financial firms and identify eight variables that significantly impact financial firms’ bond
ratings. This model gives an accuracy rate of 79.62%. We augment our eight-factor model by
adding nine additional variables identified from the CAMEL framework. Multinomial logistic
analysis on these 17 variables identifies ten significant factors (see Table 5-A). This model
gives a higher accuracy rate of 84.76% and is used for further analysis.
Additionally, we estimate our 17 variable model using the ordered logistic procedure but
find it gives a lower accuracy rate of 81.6%. Thus, we identify significant bond determinants
using the multinomial logistic model for both sample sets. We show the cross-correlation
matrix of the shortlisted factors in Table 5-B and do not observe any two variables to be
highly correlated. The framework retains four determinants from the previous model applied
to non-financial firms.
We find a significant impact of interest cost to sales ratio (used instead of operating
expenses to sales ratio), ROA, strategic ownership and market capitalization on credit
ratings. The directional relationship remains the same as in the case of non-financial firms.
Thus, we observe that CRAs in India emphasize efficiency, profitability, management quality
and market characteristics while assessing financial firms. We do not find industry
concentration as an essential driver of bond ratings in the case of financial firms. Sales [14], as
a measure of the level of operations, does not hold relevance in financial firms. Bond
characteristics do not play a vital role in the rating process for financial firms, as was in the
case of non-financial firms.
Additionally, we find six measures from the CAMEL framework to have a significant
impact on bond ratings. Financial firms with lower capital adequacy (measured with total
equity) have better bond ratings. Though financial institutions need to maintain adequate
capital as a cushion for meeting the requirements of debtholders, excess capital is not
desirable beyond the required norms. It leads to a higher cost of raising funds, negatively
impacting the overall capital cost. Prior work highlights that stringent capital requirements
should be imposed if the capital held by financial institutions is low. In the case of highly
capitalized financial institutions, an increase in capital would lead to greater exposure to risk
(See Calem and Rob, 1999) [15].
We observe that management efficiency (measured by operating expenses to total expenses
and government vs. private ownership) positively impacts credit ratings. We find firms with
higher operating expenses to sales to be rated better because there is less focus on non-
operating expenses, indicating efficiency in managing expenses. While analyzing the impact of
ownership, we theoretically hypothesize that private firms are better managed due to greater
competition and professional management. Prior work also finds higher operational risk
associated with government-owned banks (See Iannotta et al., 2013). However, contrary to our
belief and prior literature, our results show that better ratings are associated with government-
owned financial institutions, indicating they have lesser risk and better management. These
results are not surprising in light of the recent financial improprieties relating to Indian private
financial institutions and NBFCs such as IL & FS Financial Services Ltd. Dewan Housing
Finance Corporation Ltd. Axis Bank, Yes Bank and ICICI Bank, among others.
Cost to income and growth in interest income have a negative and positive impact on
ratings, respectively. These measures indicate that financial firms should have strong
MF Category 1 Category 2 Category 3
p p p
Variable Coefficient Value Coefficient Value Coefficient Value

Panel A: Bond rating determinants

IC/S
4.7563 0.0000
2.2007 0.0880
1.6683 0.1840
ROA 162.1624 0.0010 78.6581 0.1060 22.0566 0.6330
AT
3.4438 0.9260
5.3548 0.8850
85.0734 0.0220
LT/TB 2.1546 0.1630 2.1488 0.1610 2.2910 0.1470
E/A 90.0044 0.1110 109.2314 0.0520 215.9060 0.0000
SO
0.0529 0.0180 0.0018 0.9320
0.0045 0.8420
MC 1.5061 0.0000 0.3142 0.3280 0.1175 0.7180
P/B
0.0306 0.9600 0.0446 0.9390 0.2879 0.5950
NW
0.0000 0.0070
0.0000 0.0050
0.0000 0.0000
NNPA/NW
1.6692 0.0880 0.4153 0.6610 1.1657 0.2160
PCR
0.4575 0.9850 1.8161 0.9420
16.7429 0.5090
OE/TE 6.0844 0.0030 9.9485 0.0000 3.8361 0.0410
PG 0.0153 0.8230
0.0635 0.2340
0.0049 0.9290
OS 15.2061 0.0000 9.0979 0.0000 7.6237 0.0000
C/I
0.3473 0.0160
1.3003 0.0000
0.3325 0.0150
IG 15.7037 0.0000 15.9589 0.0000 12.4118 0.0030
LA/TA
9.3371 0.0020
7.6837 0.0120
8.4389 0.0110
CONSTANT
13.1774 0.0210
8.5870 0.1290
7.2076 0.2090

IC/S ROA SO MC NW OE/TE C/I IG LA/TA

Panel B: Cross-correlation matrix between nine statistically significant determinants

IC/S 1.0000
ROA
0.5259 1.0000
SO 0.3914
0.3655 1.0000
MC
0.2320 0.1251
0.3275 1.0000
NW
0.2345
0.1400
0.0846 0.6275 1.0000
OE/TE 0.0772 0.2116 0.1349
0.2591
0.3209 1.0000
C/I
0.0366
0.1281 0.0825
0.2722
0.1044 0.2858 1.0000
IG
0.0798 0.5294
0.2153 0.1063
0.1984 0.1217
0.1465 1.0000
LA/TA 0.5382
0.4820 0.1826 0.2612 0.2374
0.2923
0.1536
0.1902 1.0000
Note(s): We start estimations for financial firms using multinomial logistic regression on the previously
mentioned 16 variables used for non-financial firms. We find eight variables to impact the bond ratings of
financial firms significantly. To this, we add nine additional variables identified from the CAMEL framework.
Panel A shows the results of multinomial logistic analysis on these 17 variables. We identify ten significant
factors at the 5% level. Four out of these are the same as in the case of non-financial firms. Further, we find six
new significant determinants from the CAMEL framework. We report results for categories 1, 2 and 3 to the
Table 5. base category 4. However, to identify factors based on significance level and analyze the direction of the
Fundamental relationship, we compare only the best-rated bonds (category 1) with the base category. Panel B reports the
determinants of bond cross-correlation matrix of nine significant variables identified. The 10th significant factor (ownership
ratings for structure) is ignored, as it is a dummy variable. We do not find any two variables to be highly correlated. The
financial firms abbreviations used in the table are mentioned in Tables 2 and 3

earnings potential by increasing income and controlling wasteful expenditure. We find that
liquidity (measured by liquid assets to total assets) has an inverse impact on credit ratings, as
short-term liquid assets are expected to be less profitable. Thus, the CRAs seem to emphasize
profitability more than safety aspects for the sample firms. Our findings are consistent with
prior research (See Hassan and Barrell, 2013). We do not observe the importance of asset
quality in the credit rating process while applying the CAMEL criteria, which is contradictory
to prior work (See Pagratis and Stringa, 2007; Yuskel et al., 2015).
 We reverify the relative importance of the selected factors using the Random Forest Bond rating
method for the non-financial and financial firms, respectively (See Figure 1(a) and (b)). The determinants
selected factors play a vital role in the correct classification as per MeanDecreaseGini.
Ignoring these factors would result in a considerable prediction performance loss, as shown
and modeling
in the MeanDecreaseAccuracy for both non-financial and financial firms (See Figure 1 (a)).
Moreover, the output highlights that firm size (MC) and level of operations (TS) play a more
prominent role relatively (See MeanDecreaseAccuracy). Further, for financial firms, RF
identifies firm size (MC), Capital adequacy (NW), Management quality (SO) and profitability
(ROA) as attributes that contribute relatively more to the bond rating model prediction (See
MeanDecreaseAccuracy and MeanDecreaseGini in Figure 1(b)).

4.2 Modeling bond ratings

In this subsection, the results of the different models, including multinomial logistic
regression, ordered logit model, RF, GBM, SVM, ANN-MLP and NB, are juxtaposed. We first
compare their efficacy based on 2/3rd – 1/3rd bifurcation samples and then the five-fold cross-
validation bifurcation method for the non-financial and financial firms. Table 6 presents a
comparative performance of different models separately for non-financial and financial firms.
For non-financial firms, machine learning models, RF with 92.13%, GBM with 91.82%, SVM
with 76.79%, and ANN with 88.34% outperform the conventional statistical model with an
accuracy rate of 70.86%. NB is an exception, which shows inferior performance with an
average accuracy rate of 62.27%. Similarly, in the case of financial firms, machine learning
methods, RF (91.10%), GBM (90.10%), SVM (90.84%), and ANN (88.29%), outperform the
multinomial logit model (80.83%) and ordered logit model (74.01%), except NB, which
exhibits a prediction accuracy rate of 64.86%. The RF model seems to be the best for both
financial and non-financial firms by looking at the average accuracy rates.
The results for the five-fold cross-validation also suggest RF, with an accuracy rate of
92.8%, as the best performing model, followed by GBM (91.9%), ANN (86.0%), and SVM
(76.6%). Our statistical models again underperform vis-a-vis machine learning models except
for the NB method for non-financial firms. RF also performs better compared to all competing
models for financial firms, with an accuracy rate of 92.5%. These results are consistent with
the 2/3rd – 1/3rd bifurcation.
To gain further insights into the model’s degree of accuracy/inaccuracy, we compute the
RMD, quantifying the difference between the predicted and actual ratings. Table 7 presents
the frequency distribution for the expected value of RMD.
As mentioned earlier, an RMD with a value equal to zero shows the same accuracy rate in
Table 6. Looking at the expected value, E(Y), in Table 8, the symmetry of prediction can be
gauged. The expected absolute value indicates the average distance between the predicted
and actual rating outcomes. Standard deviation measures the variability in the expected
value of RMD. Higher is the standard deviation; more is the dispersion from the mean. Thus, a
lower expected absolute value and standard deviation indicate a better bond rating prediction
model. RF outperforms all the other models, with the least standard deviation of 0.106 for non-
financial firms and 0.111 in the case of financial firms. The RMD, measured by the expected
absolute value, is close to 0, indicating higher predictive accuracy. On the other hand, NB
exhibits the maximum standard deviation and expected absolute value, reconfirming our
previous results.
The findings are not surprising as ample evidence favors machine learning models that
accurately detect non-linear relationships and predict credit risk (Abdou and Pointon, 2011;
Wallis et al., 2019). The inferior performance of Naı€ve Bayes can be attributed to the non-
fulfillment of the assumption of independence in real life (Raschka, 2014). Among the machine
learning models, RF outperforms all other machine learning techniques (Wu and Wu, 2016).
MF

Figure 1.
(a) MeanDecrease
Accruacy and Mean
DecreaseGini for non-
financial firms, (b)
MeanDecrease
Accruacy and
MeanDecreaseGini for
financial firms
 Non-financial firms Financial firms
Bond rating
2/3rd – 1/3rd 5-Fold cross- 2/3rd – 1/3rd 5-Fold cross- determinants
Accuracy rates (AR) bifurcation (%) validation (%) bifurcation (%) validation (%) and modeling
Multinomial Logit 70.86 72.2 80.83 81.2
Ordered logit 70.14 62.2 74.01 78.9
RF 92.13 92.8 91.10 92.5
GBM 91.82 91.9 90.09 91.5
SVM 76.79 76.6 90.84 90.4
ANN – MLP 88.34 86.0 88.29 85.8
Naive Bayes 62.27 57.3 64.86 66.0
Note(s): The accuracy rate is the percentage of correctly predicted cases out of the total number of cases. We
compare the 2/3rd – 1/3rd bifurcation and the five-fold cross-validated (CV) accuracy rates of different Table 6.
techniques, multinomial logit, ordered logit, random forest (RF), gradient boosting machine (GBM), support Accuracy rates for logit
vector machine(SVM), artificial neural network (ANN – MLP), and Naı€ve Bayes (NB), for the non-financial and and machine learning
financial firm’s samples methods

Zero (%) Absolute one (%) Absolute two (%) Absolute three (%)

Panel A: Non-financial firms

Multinomial logit 70.86 22.60 6.34 0.20
Ordered Logit 74.01 26.89 5.62 0.20
RF 92.13 6.95 0.92 0.00
GBM 91.82 6.75 1.33 0.00
SVM 76.79 15.64 7.57 0.00
ANN- MLP 88.34 10.84 0.82 0.00
NB 62.27 28.02 8.59 1.12
Panel B: Financial firms
Multinomial logit 80.83 18.53 0.53 0.11
Ordered logit 74.01 23.54 1.06 0.11
RF 91.10 8.28 0.51 0.10
GBM 90.10 8.09 0.53 0.11
SVM 90.84 8.52 0.53 0.11
ANN – MLP 88.29 11.29 0.32 0.11
NB 64.86 34.40 0.64 0.11
Note(s): The table is divided into two panels – A and B for non-financial and financial, respectively. We
summarize the distribution of the rating misclassification distance, the numerical distance between the actual
and predicted rating, for the different models. A higher rating misclassification value signifies a higher
magnitude of the error. As we consider four rating classes, the absolute rating misclassification distance in our Table 7.
case ranges from 0 to 3. A value of zero indicates correct classification accuracy. Absolute one shows the Distribution of the
deviation of the model prediction by one rating misclassification (þ1 and
1) and similarly for absolute two rating misclassification
and absolute three values distance

Thus, the present study contributes to the machine learning literature by providing evidence
favoring RF performing better than other machine learning models for non-financial and
financial firms. We recommend that CRAs adopt machine learning models for credit rating
prediction to improve accuracy and prompt revision, as wrong classifications can be costly.
RF shows the highest predictive accuracy within the machine learning models and should be
preferred to build the credit rating model in the Indian context for non-financial and
financial firms.
MF Methods E(Y) SD (Y) E(jYj)

Panel A: Non-financial firms

Multinomial logit 0.015 0.498 0.359
Ordered logit
0.005 0.512 0.388
RF
0.004 0.106 0.088
GBM 0.008 0.121 0.094
SVM 0.199 0.419 0.308
ANN – MLP 0.002 0.141 0.125
NB
0.183 0.691 0.486
Panel B: financial firms
Multinomial logit 0.016 0.216 0.199
Ordered logit 0.017 0.287 0.260
RF 0.043 0.111 0.096
GBM 0.052 0.112 0.098
SVM 0.059 0.113 0.099
ANN – MLP 0.012 0.135 0.122
NB
0.149 0.357 0.360
Note(s): This table contains the expected value E(Y), absolute expected value E(jYj), and the standard
Table 8. deviation SD (Y) corresponding to each method for the non-financial (Panel A) and financial firms (Panel B). The
Expected value and expected value shows the symmetry of model prediction. The standard deviation is calculated using Jensen’s
standard deviation of inequality and measures the variability in the expected value of rating misclassification distance. The absolute
the rating expected value is computed using the absolute value of rating misclassification and indicates the average
misclassification distance between the predicted and actual rating outcome. A lower expected absolute value and standard
distance deviation indicate a better bond rating prediction model

5. Conclusion
The study identifies significant credit rating drivers for non-financial and financial firms in
the Indian market, a large emerging economy. We find that different rating determinants
impact both sets of firms, and the CAMEL framework plays a significant role in the rating
process of financial firms. We find that ten factors significantly affect the ratings of non-
financial firms. CRAs assign better ratings to firms that belong to industries with a higher
level of concentration, those with a larger level of total sales and DOL, better operating
efficiency, higher profitability and solvency, lower strategic ownership, higher experience,
larger size, and price-to-book value ratio.
While analyzing the ratings of financial firms, we again find the importance of 10 factors,
including four determinants that were also relevant for non-financial firms. We observe better
ratings assigned to firms with higher operating efficiency and profitability, lower strategic
ownership, and larger size. Six additional drivers relating to the CAMEL approach seem to
play a vital role in the bond rating process. Higher ratings are assigned to financial firms with
lower total equity, higher operating expenses to total expenses ratio, Government ownership,
improved cost and revenue efficiency and lower liquidity.
Most of our findings are in line with prior studies in developed markets. However, contrary
to prior work and theoretical beliefs, a few distinct points are highlighted in our study. We
observe that Indian CRAs do not focus on the bond characteristics for non-financial and
financial firms. Thus, they do not distinguish between the issue and issuer-specific ratings.
As the credit rating market matures in emerging economies, a distinction should be made
between bond ratings and corporate ratings. Looking at the rating methodology of financial
firms, we find that Indian CRAs assign better ratings to institutions with higher government
ownership, which is not surprising in light of the recent financial improprieties relating to
Indian private financial institutions.
 In contrast with developed market evidence, the role of asset quality in bond ratings is not Bond rating
confirmed in the Indian context. Further, rating agencies in India focus more on the determinants
profitability of assets rather than maintaining a safe cushion with liquid assets, which leads
to the inability of rating agencies to predict significant downgrades. Similar evidence is
and modeling
reported in earlier work for developed markets. Indian CRAs should carefully assess and
incorporate these findings to develop better predictive models.
Examining the bond rating prediction models, we conclude that machine learning
techniques outperform conventional statistical models except for NB, consistent with prior
work. The RF method is found to be the most appropriate bond rating prediction technique in
the Indian setting for both non-financial and financial firms. However, the results on the
efficacy of alternative machine learning techniques in rating prediction are mixed for
developed markets (See Wu et al., 2022).
The study significantly contributes to the current work and is relevant for CRAs and
investors. It provides comprehensive literature on credit rating modeling, wherein a separate
framework for non-financial and financial firms is identified. Our results support the
superiority of machine learning methods such as RF for modeling bond ratings, verified for
both sets of sample firms. We observe some differences in the credit rating determinants as
well as modeling between India and developed markets, which need to be kept in mind while
comparing the cross-country ratings. However, in further research, we need to examine the
evidence for other emerging markets to arrive at more robust conclusions.
Notes
1. https://www.sebi.gov.in/commondata/recognised/Registered-Credit-Rating-Agencies.pdf
2. See, for example, Jiang et al. (2012), Strobl and Xia (2012), Cornaggia and Cornaggia (2013), Partnoy
(1999, 2006, 2017), Coffee and Coffee Jr (2006), and Darbellay and Partnoy (2012).
3. CAMEL refers to capital adequacy, asset quality, management efficiency, earnings quality and
liquidity (See Gambetta et al., 2019; Forgione and Migliardo, 2018; Chodnicka-Jaworska and
Jaworski, 2017; Kocenda and Iwasaki, 2020; Bersch et al., 2020).
4. Bank for international settlements (BIS) requires the bank to use credit rating to measure credit risk
under its standardized approach.
5. In India, non-performing loans to total loans have increased from 2.4% in 2008 to 9.2% in 2019. With
gross NPA at 10.3% in the September 2021-ended quarter, India ranks 33 among 137 countries,
when ranked in descending order, as per IMF Data (Nair, 2019).
6. Ordered probit model, unordered logit model, multivariate probit model, ordered linear probit
model, ordered semiparametric probit model, polytomous ordered probit analysis, among others
7. Two alternative ways to group the rating data have been used in the prior work. The first is to
combine the rating categories to ensure an adequate number of observations (See Kim and Ahn,
2012). The second is to consider only a subsample of ratings with many observations, such as
Pinches and Mingo (1973). We follow the first approach for a more comprehensive analysis.
8. For cases where more than one rating was assigned during the year, only the rating in June is
considered in our model. If there is no change in the rating, we take it to be the same for the following
year, as CRAs have not changed the credit standing of the particular issue.
9. 70 explanatory variables for all firms include two determinants for industry characteristics, 12 for
business characteristics, 44 for financial characteristics, six for managerial characteristics, five for
market characteristics, and one for bond characteristics.
10. Based on the CAMEL framework, we choose 29 variables, which comprise three measures of capital
adequacy, nine of asset quality, 10 of management efficiency, four of earnings quality and three of
liquidity. Although managerial characteristics were included in the previous model for non-
financial firms, we additionally include another dimension relating to management efficiency while
analyzing the rating process of financial firms.
MF 11. Correlation values up to 0.6 result in a variance inflation factor (VIF) of 1.56, which is acceptable.
Hair et al. (1995) highlight that VIF up to 10 is not considered problematic.
12. https://www.probabilitycourse.com/chapter6/6_2_5_jensen’s_inequality.php
13. In this case, large strategic investors, are likely to control managerial functions in their interest.
They may force managers to disregard bondholders’ perspectives leading to agency problems.
Thus, CRAs in India perceive a negative relation between strategic ownership and ratings assigned.
14. Sales of financial firms are measured by operating income which depends on the level of deposits
and is time-varying.
15. Firms with marginally higher equity capital will be exposed to greater risk during periods of
distress as equity holders have the last right on liquidation values in the event of winding up.

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Corresponding author
Tarunika Jain Agrawal can be contacted at: tarunika.jain@gmail.com

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