What Is A Credit Rating?
In the previous unit, we have learned the importance of checking the credit rating of any bond while investing. So, here in this section, we will elaborate and understand the concept of credit rating and how these bonds are rated by several credit rating agencies.
Like all the other financial instruments, debt securities carry significant risks with them. This is why it is important to evaluate the credit quality of a debt security. All in all, a bad quality of debt security should be ignored by us.
As a part of the credit rating process, bonds, or any other debt instruments are rated based on their risk of default, i.e., the ability of the issuer to repay the debt it has taken.
Credit Ratings signify the creditworthiness of a company by assigning a rating to it.
Under the credit rating process, several factors like the payment history of a company, its financials, the amount it owns, etc., are evaluated and a credit rating is assigned to that security. These ratings are carried out by different Rating Agencies who are experts in this field.
Some of the major credit rating agencies in India are:
CRISIL is an Indian analytical company which provides ratings, research, risk and policy advisory services and is a subsidiary of S&P Global.
CRISIL is the first credit rating agency of India and was established in 1988 by the ICICI and UTI jointly. In April 2005, US based credit rating agency S&P acquired a majority stake in the company
As of December 2020, CRISIL’s revenue is ₹20,763 million (US$290 million) and a net income of ₹3,547 million (US$50 million).
Moody's Investors Service, also referred to as Moody's is the bond credit rating business of Moody's Corporation and represents the company's traditional line of business. The company provides financial research on bonds and other debt securities which are issued by commercial and government entities. Moody's, along with S&P and Fitch Group, is considered to be one of the Big Three credit rating agencies in the world.
3. India Ratings & Research:
India Ratings and Research is India's one of the most respected credit rating agencies. The Company is built on a foundation of independent thinking, rigorous analytics. The company has grown rapidly during the past decade and has gained significant market share in India's fixed income market. It is a 100% owned subsidiary of the Fitch Group.
The ratings do not convey other risks which can be present in a company like its liquidity position, etc.
A low-rated company has a high chance of defaulting on its payments when compared to a company whose credit rating is high.
All the agencies require to disclose the credit ratings that they have assigned on their website and other platforms.
As common investors, we can look at the ratings before making a buy decision.
One thing to remember is that credit rating agencies only evaluate the creditworthiness of a company. They do not evaluate other risks like market risk, reinvestment risk, etc.
This is why we should use credit ratings to evaluate the credit risk of a company and nothing else.
Credit Rating Agencies try to provide an independent and impartial opinion of the credit risk of a company which is seeking to raise money.
Here is a list of the Rating scale of major Rating Agencies in India:
In the above table, we can see the different ratings that are assigned by the rating agencies. These ratings are for debt instruments that have a maturity of 1 year or more.
Short-term maturity instruments have different rating scales.
AAA is the highest rating, whereas D means Default, i.e., the company is about to default on its payments or has already defaulted.
Bonds with ratings on or above CRISIL BBB are considered to be Investment Grade whereas bonds with ratings below CRISIL BBB are considered to be Non-Investment or Junk Grade bonds.
Credit Rating Agencies also have some risks:
1. Credit Ratings are dynamic in nature:
A company’s default risk keeps changing over time. All in all, high rated bonds are more stable than low-rate bonds.
2. Rating Agencies are not perfect:
There is a probability that rating agencies fail to correctly measure a risk. Relying on rating agencies without doing your own research is a bad idea.
3. Event Risk is difficult to measure:
As easy as it sounds, the probability of default is very difficult to measure. Risks like natural disasters, mergers and acquisitions are hard to predict. In that case, the ratings become unreliable.