What is the meaning of credit rating?
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When an independent agency assesses the creditworthiness of a borrower, it provides a rating, which is known as a credit rating.
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Credit Rating
By Bajaj Broking Team
September 17, 2024
4 mins read
Share Market
Synopsis:
Credit ratings are assigned by independent agencies to various kinds of borrowers based on their ability and willingness to pay their debts. A borrower with a high credit rating is highly likely to pay the interest and principal due on its debt. Conversely, a borrower with a low credit rating is not likely to do so. Many factors go into deciding these ratings, like a borrower’s payment history, cash flows, net profit, and general economic outlook. Such ratings can provide vital cues while making debt investments. In India, prominent credit rating agencies include CRISIL, ICRA, CARE, and India Ratings & Research.
Credit ratings are an assessment by an independent agency about a borrower’s ability and willingness to pay its debt. A borrower can be a government, a public sector undertaking, a private company, or an individual.
While making this assessment, an agency examines whether a borrower can pay both the interest and principal outstanding within the due date or not. Based on the analysis, a credit rating is assigned. Read this blog, as it explains the types of credit ratings, how to invest based on credit ratings, and advantages and limitations of such ratings.
What is a Credit Rating?
Types of Credit Ratings in India
Prominent types of credit ratings in India are described below:
a) Corporate Ratings: Private companies raise debt through many instruments, like commercial papers, bonds, etc. When a rating agency assigns a credit rating to the debt issued by private companies, such ratings are called corporate ratings.
b) Sovereign Ratings: The Central Government of India raises debt for various purposes, like investing in long-term projects. The ratings assigned to the debt raised by the Central Government are called sovereign ratings.
c) Municipal Bond Ratings: Municipalities or local government bodies also raise debt in India from time to time. When credit rating agencies examine the ability of municipalities to pay the debt raised, they assign a rating, known as municipal bond rating.
d) Structured Finance Ratings: In India, banks pool loans like housing loans and auto loans and issue mortgage-backed securities (MBS) or asset-backed securities (ABS). Rating agencies analyse such securities to find their default risk and assign credit ratings to them, known as structured finance ratings.
e) Bank Loan Ratings: When a bank extends a loan to a corporate or an individual, it takes a risk because a borrower may or may not be able to pay the loan. Ratings assigned to such loans are known as bank loan ratings.
Example of Credit Ratings
1. It’s easy to understand these ratings with an example. Typically, agencies provide these ratings in this format.
2. For issuers with the highest creditworthiness, typically credit ratings like AAA, AA, and A are assigned.
3. Then, we have BBB, BB, and B. This is followed by CCC, CC, and C.
4. A debt with a D rating means that the issuer cannot pay the interest and principal due on time.
5. As we move from AAA to D, the creditworthiness reduces.
6. Different agencies have different ways of providing credit ratings. For example, some agencies may even provide an A+ rating to a debt.
Importance of Credit Ratings
1. When a borrower (a government, a private company, etc.) gets a high credit rating, it can raise funds relatively easily because a high rating signifies that it is able to service its loans.
2. Credit ratings (whether low or high) send a signal to investors as to whether they should invest in a debt instrument or not. If a debt instrument has a high rating, the probability is high that its issuer will be able to pay for it. Hence, investors can consider investing in such an instrument.
Factors of Credit Ratings
A number of factors go into deciding the credit rating of an entity. The main factors are discussed below:
a) Borrower’s payment history: This is the most important factor when assigning a credit rating. Whether a borrower has paid interest and principal due on all its debt in the past or not has a huge impact on its credit ratings.
b) Current debt level: A borrower’s current debt level also impacts its credit ratings. Besides, the nature of debt (e.g., whether it’s secured or unsecured) also has a bearing on such ratings.
c) Cash flows and net profit levels: A borrower needs cash flows to pay the debt. And, its net profit has an impact on its interest coverage ratio. Hence, these two factors play an important role in assigning credit ratings to him.
d) Overall economic and market conditions: A country’s economic and market conditions can impact a borrower’s ability to service its debt. Hence, a rating agency must consider such conditions while assigning credit ratings.
Who Assesses Credit Rating?
Credit ratings are assessed by independent agencies that specialize in evaluating the creditworthiness of borrowers. These agencies conduct in-depth financial analysis, considering various factors such as payment history, debt levels, cash flow, and overall economic conditions. Their role is crucial in determining whether an entity—be it a company, government, or financial institution—can meet its debt obligations.
Regulatory bodies often oversee these agencies to ensure credibility and transparency in the credit assessment process. In India, credit rating agencies operate under the oversight of the Securities and Exchange Board of India (SEBI), which enforces stringent regulations to maintain transparency and reliability. Similarly, international agencies like Moody’s, S&P Global Ratings, and Fitch Ratings dominate global credit evaluation.
Credit rating agencies use standardized methodologies to assign ratings, offering valuable insights to investors and lenders. Their assessments influence borrowing costs, investment decisions, and even regulatory compliance. A strong rating typically results in lower interest rates, while a poor rating may restrict access to funding.
Major Types of Credit Rating
Credit ratings are classified based on the type of borrower and financial instrument being assessed. Below are the major types of credit ratings:
- Corporate Credit Rating: Assigned to private companies issuing bonds, commercial papers, or other debt instruments.
- Sovereign Credit Rating: Evaluates a country's ability to meet its financial obligations, impacting foreign investments.
- Municipal Bond Rating: Assesses local government bodies and their capability to repay issued bonds.
- Structured Finance Rating: Given to asset-backed securities such as mortgage-backed securities (MBS) and auto loan-backed securities.
- Bank Loan Rating: Determines the creditworthiness of loans issued by banks to corporations or individuals.
These ratings provide investors with a comprehensive understanding of the risk associated with different debt instruments and borrowers.
Users of Credit Ratings
Credit ratings are used by multiple stakeholders in the financial ecosystem to make informed decisions regarding debt instruments. Investors, financial institutions, corporations, and regulators rely on these assessments to evaluate risks and returns.
Institutional investors such as mutual funds, pension funds, and insurance companies utilize credit ratings to determine where to allocate capital. Banks and lending institutions use these ratings to assess the creditworthiness of borrowers and structure loan terms accordingly. Corporations, on the other hand, depend on favorable credit ratings to secure funding at lower interest rates. Governments also use ratings to attract global investors and secure external funding when needed.
The key users of credit rating can be classified as follows:
- Retail and institutional investors: Assess the risk associated with bonds and debt instruments.
- Banks and financial institutions: Determine lending risks and set loan interest rates.
- Corporations: Seek high ratings to lower borrowing costs and attract investors.
- Regulatory bodies: Monitor financial stability and ensure compliance.
By offering a standardized measure of credit risk, these ratings serve as an essential tool for decision-making across industries.
Understanding Credit Scores
Credit scores are numerical representations of an individual's creditworthiness, distinct from corporate or sovereign credit ratings. These scores are primarily used by banks and financial institutions to assess an individual's ability to repay loans and manage debt responsibly. A high credit score enhances borrowing opportunities, while a low score can limit access to financial products.
In India, credit scores are provided by agencies such as CIBIL, Experian, Equifax, and CRIF High Mark. These agencies analyze factors like repayment history, outstanding loans, credit utilization ratio, and duration of credit history to generate a score ranging from 300 to 900. Generally, a score above 750 is considered favorable for obtaining credit at competitive interest rates.
Maintaining a strong credit score requires timely repayment of loans, maintaining a low credit utilization ratio, and avoiding multiple loan applications within a short period. Any missed payments, defaults, or high levels of unsecured debt can negatively impact the score.
Lenders use credit scores to determine loan eligibility, interest rates, and credit limits. Individuals with higher scores often enjoy lower interest rates, higher borrowing limits, and faster loan approvals, making it a key factor in personal financial management.
List of Credit Rating Agencies in India
Find below a list of leading credit rating agencies in India:
a) CRISIL: CRISIL is a leading credit-rating agency in India, which provides ratings on a variety of debt instruments. Its majority shareholder is S&P Global Inc., a major provider of ratings worldwide.
b) CARE: CARE is a famous provider of credit ratings to diverse industries, such as infrastructure, manufacturing, banking, and non-banking financial services.
c) ICRA: ICRA is also famous for being an independent credit rating agency, which provides ratings to a vast range of industries in India.
d) India Ratings & Research: This company is a subsidiary of the Fitch Group. It provides ratings to private companies, banks, insurance companies, urban local bodies, finance and leasing companies, and project finance companies.
Pros & Cons of Credit Ratings to Investors
Advantages of credit ratings to investors:
a) Such ratings help investors decide whether they should invest in a particular debt instrument or not.
b) If a debt instrument has a high credit rating, it means that its issuer is most likely to pay the interest and principal due on it, and vice versa.
c) If an individual has a high credit rating as a borrower, it means he can get loans at a relatively lower rate than those individuals without a high credit rating.
Disadvantages of such ratings from investors’ perspective:
a) A credit rating is only as good as the information it is based on. At times, companies do not provide sufficient information to a rating agency. In such a case, the credit rating issued by an agency may not help investors or it could be misleading.
b) Credit ratings depend upon a borrower’s ability to pay its debt in the future. No matter how good the assumptions are, the future remains uncertain to a large extent. Hence, there’s always an element of risk with credit ratings.
c) Credit ratings are subject to change from time to time as the creditworthiness of an issuer changes. So, an investor may put his funds in an instrument today with a high credit rating, but a year from now, its credit rating may be downgraded.
d) At times, an issuer gets different credit ratings from different agencies. For example, one agency can give a AAA rating to an issuer; however, another agency can provide an A rating, which can confuse an investor.
Pros & Cons of Credit Ratings to Issuers
Advantages of credit ratings to issuers:
a) A corporation with a high credit rating can issue debt at a lower rate of interest because a high rating shows that it can pay its debt easily.
b) A company with a high credit rating can approach investors multiple times to raise funds. Hence, it can borrow more (provided it maintains its high credit rating) than a company with a low credit rating.
c) Companies often use their high credit rating to market their brand. They tend to enjoy a higher goodwill than companies with a low credit rating.
Disadvantages of such ratings from issuers’ perspective:
a) It can be expensive for a company to get a credit rating from a reputed agency. Typically, there’s a fee associated with it, as a rating agency has to thoroughly analyse the creditworthiness of an issuer.
b) Often when a rating agency downgrades the credit rating of a company, it results in a massive decline in its share price.
Pros & Cons of Credit Ratings to Financial Intermediaries
Advantages of credit ratings to financial intermediaries:
a) Financial intermediaries, like banks and brokers, can assess the creditworthiness of an issuer using credit ratings. For example, if a company has a low credit rating, a bank may not provide it a loan or charge it a very high interest rate for a loan.
b) Based on credit ratings, financial intermediaries often advise their clients on where to invest, depending on their clients' risk-bearing capacity. For example, if a client has a very high capacity to bear risk, an intermediary may recommend a bond with a low credit rating to him which provides a high rate of interest.
Disadvantages of credit ratings to financial intermediaries:
a) Almost all disadvantages of such ratings from investors’ perspective are applicable here as well.
b) A credit rating explains only the credit risk of a debt instrument or a bond. However, there are many other risks in such investments, like price risk, inflation risk, and liquidity risk. Even a highly rated bond can provide a low return due to the risks not captured by credit ratings. Hence, it’s risky for an intermediary to recommend a bond to his client based only on credit ratings.
Pros & Cons of Credit Ratings to Regulators
Advantages of credit ratings to regulators:
a) Such ratings help regulators monitor the creditworthiness of various players in the financial market, like private companies, public sector undertakings, and even government bodies.
b) Credit ratings can also provide early signals of credit deterioration in an economy. For example, if many companies start witnessing a downgrade in their credit ratings, then it can be a systematic issue and regulators may need to step in.
Disadvantages of credit ratings to regulators:
a) All the disadvantages of such ratings from investors’ perspective are relevant from the viewpoint of regulators, too.
Things to Remember Before Making Investment Decisions Using Credit Ratings (need to add approx. 150 words content in a listicle format)
Conclusion
No matter what kind of an investor you are, credit ratings can be extremely important for your portfolio management. Hence, you must always consider them while making a debt investment. In fact, it’s a good idea to consider a company’s credit rating even before buying its stock because if it has a poor rating, then its share price may fall in the future. That said, you should also understand the limitations of such ratings and don’t make an investment decision based solely on them.
Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
For All Disclaimers Click Here: https://bit.ly/3Tcsfuc
Frequently Asked Questions
How are credit ratings determined?
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Credit ratings are based on an issuer’s payment history, current debt level, cash flows, net profit levels, and overall economic and market conditions.
What do the different credit rating categories mean?
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Rating agencies use different categories for credit ratings, like AAA, AA, A, BBB, BB, B, CCC, CC, C, and D. A bond with a AAA rating has the highest creditworthiness and a bond with a D rating has the worst creditworthiness. D rating means the issuer is not able to pay the interest/principal due in time.
How can I improve my credit rating?
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You can improve your credit rating by improving your payment record, cashflows, and net profit.
What are the consequences of a poor credit rating?
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A borrower with a poor credit rating may not be able to raise funds. Even if such a borrower is able to raise funds, he will have to pay a much higher rate of interest than a borrower with a high credit rating.
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