Credit rating is a measure of a business entity’s ability to repay a financial obligation based on its income and past repayment history. Credit rating agencies (CRAs) take into consideration several factors like the financial statements, debt history, lending and borrowing history, the ability to repay the debt, etc. before giving a company its credit score. Companies with a higher credit rating will be seen as lower risk and therefore get loan applications approved more easily and faster if required and it also shows investors the likelihood of a company defaulting on its debt obligations or outstanding bonds is much lower.
CRAs typically rate different investment instruments such as debt securities, short term debt instruments like commercial papers, structured debt obligations, loans, and fixed deposits
SEBI (Securities and Exchange Board of India) authorizes and regulates all credit rating agencies in India as per its regulation. There are seven credit rating agencies in India, they are – CRISIL, CARE, ICRA, SMREA, Brickwork Rating, India Rating, and Research Pvt. Ltd, and Infomerics Valuation and Rating Private Limited.
How does it work?
Companies seeking to raise debt request a rating from the CRA. They then sign a rating agreement, which provides the terms of the CRA’s engagement and gives the CRA access to the issuer’s information and using this the credit rating agencies assess and assign credit ratings to securities of companies in numerous industries and they take into consideration several factors including strategic initiatives, company operations, competitive position, financial performance, overall industry dynamics, etc. But each of the 7 credit rating agencies considers different factors while rating. Once the credit rating agencies assess the company, they provide investors with information about whether bond and debt instrument issuers can meet their obligations and they also provide additional analysis for investors so that they can make informed decisions.
Major factors considered by different rating agencies in India:
- Payment History.
- Credit Utilisation.
- Credit History Duration.
- Credit Mix.
- New Credit.
- Industry risks.
- Regulatory environment etc.
Types of credit rating:
Companies offer long-term instruments, whose ratings lie on a spectrum ranging from the highest credit quality (AAA) to lower quality or “junk”(<BBB).
- AAA – This rating is considered to have the highest degree of safety regarding timely servicing of financial obligations (Safest). They have the strongest capacity to repay investors due to their strong financial positions which give them the lowest chance of default.
- AA – This rating is considered to have a very high degree of safety regarding timely servicing of financial obligations (Safer). They have a lower chance of default.
- A – This rating is considered to have an adequate degree of safety regarding timely servicing of financial obligations (Safe). They have a low chance of default.
- BBB – This rating is considered to have a moderate degree of safety regarding timely servicing of financial obligations (Relatively risky). They have a moderate chance of default.
- BB, B & C – This rating is considered to have a high risk of default regarding timely servicing of financial obligations (Very risky or “Junk”). These instruments have a high to very high chance of default.
- D – Companies with this rating are in default or are expected to be in default soon.
Controversies surrounding credit rating agencies:
CRAs have been involved and even bore some responsibility for some of the major economic events, one that pops to mind immediately is the 2008 financial crisis, where the agencies underestimated the credit risk associated with structured credit products such as CDOs, etc. and failed to adjust their ratings hence CRAs were accused of both methodological errors and conflicts of interests cases since the companies would have to pay the CRAs to get themselves rated so there would be some biases.
There are some more issues associated with CRAs such as they might favour certain political ideologies and some may even be politically motivated, For e.g. after Crimea annexation rating agencies downgraded the rating of Russia.
Since there is no uniformity among the credit rating agencies in India, investors might not able to understand the different credit ratings by different CRAs.
Credit rating agencies play a crucial role in the capital market by assessing the credit risk of different investment instruments and the creditworthiness of borrowers, thereby providing investors with information in order to make informed decisions. The ratings also help governments from emerging and developing countries to issue bonds to domestic as well as international investors. Regulators such as RBI sometimes even use CRAs to improve the awareness and decision-making of their regulated entities. But there are some controversies too as mentioned above and at the end of the day, the credit rating is an opinion even if it is from a recognized entity hence investors looking into investing in different investment instruments should do more research on the instruments in addition to looking at the ratings and analysis given by the agencies and all the investments should be based on your risk appetite and investment horizon.
This article should not be construed as investment advise, please consult your Investment Adviser before making any sound investment decision. If you do not have one visit mymoneysage.in