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Credit ratings play an important role in the world of finance. It indicates the safety or risks associated with different securities (stocks, fixed-income securities like bonds, etc.) and their issuers. It provides crucial insights into the world of investments. In this article, we will discover what credit ratings are, how they work, and their role in the financial markets. We will also explore the different credit rating agencies and their credit ratings.

What are Credit Ratings?

A credit rating is an assessment of the creditworthiness of a borrower, whether it’s an individual, a corporation, or a government. It is a symbol assigned to a security or issuer that represents its creditworthiness or safety. Credit rating agencies (CRAs) are responsible for assigning these ratings. Their primary goal is to provide a standardised evaluation of credit risk, which allows lenders and investors to make informed decisions regarding lending or investing in debt securities.

Credit ratings are generally expressed as letter grades, such as “AAA,” “BBB,” or “C.” Each rating corresponds to a level of credit risk and reliability. The specific rating scale may vary slightly between different credit rating agencies, but the core principles remain the same. The three major global credit rating agencies (CRAs) – Moody’s, S&P, and Fitch use similar, symbol-based ratings to assess a bond issue’s risk of default.

The chart given below ranks the long-term ratings of CRAs from highest to lowest.:

Bonds with high-quality grade ratings are the safest and carry lower interest rates. On the other hand, low-grade or speculative-grade issues are the riskiest and carry high interest rates as they involve greater risk. Credit rating agencies assign default ratings to bonds that have defaulted on their payment obligations.

Moreover, rating agencies will typically provide outlooks on their respective ratings. The outlook can be positive, stable, or negative. They may also offer additional signals about the possible future direction of their ratings, like indicating that a bond is ‘On Review for Downgrade’ or ‘On Credit Watch for an Upgrade’.

What is Credit Risk?

Credit risk is the risk of loss resulting from the issuer’s failure to make full and timely payments of interest and/or principal. Credit risk has two components:

1. Default Risk/Default Probability: It is the probability that a borrower defaults. A borrower is said to be in default if they fail to make full and timely payment of principal and interest as per the terms of the debt security.

2. Loss Severity: The second component is the loss severity in the event of default. It is the portion of a bond’s value (including unpaid interest) an investor loses. A default can lead to losses of various magnitudes.

You can summarize the credit risk of a security or issuer as the expected loss.

Expected loss = Default probability × Loss severity

You can express the expected loss either as a monetary amount (e.g., ₹4,50,000) or as a percentage of the principal amount (e.g., 45%).

What are Credit Rating Agencies?

Credit Rating Agencies (CRAs) are independent entities that assess and assign credit ratings to various debt issuers and their securities. These agencies provide valuable insights into the creditworthiness of governments, corporations, and other entities.

CRAs are independent organisations, which means that they are separate from the entities they rate. These agencies must be independent to avoid conflict of interest. They evaluate the issuer based on various criteria and assign a credit rating. The rating symbols vary depending on the rating agency. Moody’s, Standard & Poor’s (S&P), Fitch Ratings, Credit CRISIL, CARE, and ICRA are among the top credit rating agencies.

Common Credit Rating Categories

Here are some of the common credit rating categories:

Investment Grade:
- AAA (or Aaa): The highest credit quality with the lowest risk of default.
- AA (or Aa): High credit quality with a very low risk of default.
- A: Good credit quality with a low risk of default.
- BBB (or Baa): Adequate credit quality with a moderate risk of default.
Speculative Grade (or Non-Investment Grade):
- BB: Speculative credit quality with a moderate risk of default.
- B: Highly speculative credit quality with a significant risk of default.
- CCC: Substantial credit risk with a high risk of default.
- D: In default or near default.

How Do CRAs Assign Credit Ratings?

Credit rating agencies evaluate both quantitative and qualitative aspects of borrowers, including:

Financial Statements: They review financial statements such as balance sheets, income statements, and cash flow statements to assess the financial health and stability of the borrower.
Credit History: CRAs analyse the credit history of individuals and the repayment history of corporations and governments to assess their ability to meet financial obligations.
Economic and Industry Factors: Agencies consider the broader economic environment and the specific industry or sector in which the borrower operates to understand the challenges and growth opportunities it may face.
Debt Structure: CRAs examine the structure of the borrower’s debt, including the types of debt securities issued and their terms to evaluate repayment capacity.
Market Conditions: Current market conditions and trends, including interest rates and inflation, are considered to assess potential risks.
Management and Governance: Credit rating agencies scrutinize the quality of management and governance practices of corporations to understand how effectively the entity is managed.

After analysing these factors, credit rating agencies assign a rating that reflects the borrower’s creditworthiness and likelihood of default. The specific rating categories can vary between agencies, but they generally follow a similar pattern.

How do Credit Ratings Affect Borrowing Costs?

Lenders and investors consider borrowers with higher credit ratings as less risky. As a result, they can access loans and credit at lower interest rates. Meanwhile, borrowers with lower credit ratings are considered riskier. So lenders charge higher interest rates to compensate for the increased risk. Entities with better credit ratings pay lower interest rates on their debt.

For example, a bond with an AAA rating will have lower interest rates, compared to a BBB-rated bond (if all other factors remain the same).

Why are Credit Ratings Important?

Risk Assessment: Credit ratings help investors and lenders assess the credit risk associated with a particular borrower. A higher credit rating indicates lower risk, while a lower rating suggests higher risk.
Pricing of Debt: Borrowers with better credit ratings can access credit (loans) at lower interest rates because they are considered less risky. Meanwhile, borrowers with lower ratings may face higher borrowing costs.
Investment Decisions: Investors, including individuals, mutual funds, and institutional investors, use credit ratings to make informed decisions about investing in debt securities. Investors often consider higher-rated securities as safer investments.
Regulatory Compliance: Many financial institutions and regulations require a minimum credit rating for certain types of investments or transactions to ensure a level of risk management.
Risk Diversification: Credit ratings help diversify risk in investment portfolios by allowing investors to allocate funds to securities with varying risk levels.

What are the Risks of Relying on Credit Ratings?

Credit rating agencies are paid by the companies and governments that they rate. This can create a conflict of interest, as the agencies may be incentivized to give higher ratings to their clients.
CRAs can make mistakes, and these mistakes can have a significant impact on investors. For example, in 2008, Standard & Poor’s gave high ratings to many mortgage-backed securities in the US that later defaulted. This led to billions of dollars in losses for investors.
These agencies are not required to disclose their rating methodologies. This makes it difficult for investors to assess the accuracy of their ratings.
Credit ratings tend to lag the market’s pricing of credit risk.

It’s important to note that investors should use credit ratings in combination with other factors, especially their own research & analysis, while making investment decisions.

In conclusion, credit ratings are essential tools in the financial world, providing a standardized way to assess credit risk and make informed investment and lending decisions. Whether you’re an investor looking to diversify your portfolio or a borrower seeking to access capital, understanding credit ratings is key to navigating the complex landscape of finance.

Credit Rating Agencies(CRAs) are generally privately-owned entities that do the job of rating securities like bonds, debentures, shares, and other instruments. Believe it or not, but Credit Rating Agencies(CRAs) seem to be running the show globally.

Standard and Poor(S&P), Moody’s, and Fitch group are known as the ‘Big Three’ and own close to 80% in the international credit rating. Each of the three has a setup in India, that is:

CRISIL, an S&P Global Company
India Ratings(Ind-Ra), a wholly-owned subsidiary of Fitch Ratings
ICRA, a subsidiary of Moody’s
CARE, not owned by either of the Big Three.

CARE, CRISIL, and ICRA are listed on National Stock Exchange(NSE) and Bombay Stock Exchange(BSE).

CRAs have been controversial for almost half a century. They have been deemed responsible for a few of the many financial or industry crises throughout history; Penn Central Rail Road Crisis and the infamous 2008 Housing Market Crisis to name a few. In India, the IL&FS crisis is said to have taken place due to improper credit ratings.

In this piece, we explore how credit rating agencies make money, what is so special about them and how they perform on Dalal Street.

The Business Model

Broadly speaking, a CRA has three sources of revenue:

Ratings
Research
Advisory

Ratings

Every time a company issues a bond, it has to get rated by a CRA as per norms set by regulatory agencies globally. Based on risk and credit analysis, credit ratings of bonds range from AAA(+/-), AA(+/-), A(+/-) to………. CCC, CC, C D. AAA is considered as the highest grade, and D is considered the lowest grade. If a bond is rated higher, generally it shall receive more buyers in the market since it is less risky. If the bond is rated lower, it shall be deemed risky and generally receive fewer holders.

Every time a company issues a bond, it has to get the bond rated for a price. The rating markets follow the more popular ‘Issuer-Pays Model’ where the issuer or the company issuing the bond pays the CRA to get itself rated. This wasn’t always the case though,

In the 1970s, there was an ‘Investor-Pays Model’ that lost popularity over time, where the buyer of the bond had to actually pay the CRA to access the ratings.

Another major source of income for CRAs is Bank Loan Ratings. Every time a company or an individual borrows money from a bank, a Credit Rating Agency has to rate the borrower based on several factors. Bank refers to the credit report before granting a loan.

Apart from bonds and loans, CRAs have to rate MSMEs, companies, other debt instruments, shares and even the economy of countries. All of these contribute to the revenue stream.

Research

If you have ever gone through a Red Herring Prospectus(RHP) or a report a company files before an IPO, chances are that the report contains research done by a CRA. Banks, companies, and even governments hire credit rating agencies to conduct research on a requirement basis. Sometimes CRAs release reports in the public domain for marketing and maintains their position and reputation in the market.

There have been instances where CRAs have released a negative outlook towards a company or a sector its share price fell on the stock markets. This is how important a research report by a CRA is. A research report by an established CRA gives a clear picture to investors as well as organizations to make well-informed decisions.

Advisory

CRAs have all the data they need in the world. This gives them a better insight into global markets than many businesses. This is why businesses even avail advisory services offered by CRAs. This is done on a contractual basis for the necessary period.

Credit Rating Agencies As An Investment Option

Credit Rating Agencies despite running the show haven’t been running up themselves when it comes to investor returns. Their stocks have caught up only in the past year because of the bull run seen in the Indian markets. Even there, the stocks of ICRA, CRISIL and CARE ratings have barely managed to beat the NIFTY 50 benchmark index. Coming to return on investment for the past one year, CRISIL has returned ~76%, CARE Ratings returned ~69% and ICRA returned ~29%. Even here, the shares did not spike up in one go, rather they moved up in a consolidated manner over a period of time.

The Revenue and Net Profit of CRAs haven’t been consistent for the past three years. This is since CRAs aren’t selling a straightforward product. They are selling an opinion. If their customer doesn’t like it, they can always move on to the rival CRA and get a better rating.

The Big Picture

In 2008, there was a global financial crisis. It all started when CRAs gave a higher rating to bonds with a poor asset or credit quality. They were bribed/incentivized to do so. Yet, there was no action taken against them even after a global downturn.

In India, something similar happened during the IL&FS crisis in 2016. CRAs gave the now failed IL&FS securities a good rating despite knowing of poor asset quality and financial condition of the company. IL&FS did not pay back the money it had borrowed from banks and lenders. Finally, it led to a major credit crunch in the system where banks and financial services companies were hesitant to lend money and the economy remains affected by it even in 2021.

The sector runs in an Oligopoly. Apart from the Big Three, there are only a few independent CRAs, this means that only a few entities get all the business. Barriers to entering the market are high and opportunities are less. Even if the CRAs play foul, SEBI can atmost fine them as they did in the IL&FS crisis in 2016.

In popular opinion, there is rising support for the ‘Regulator Pays Model’ for CRAs where market regulators like SEBI(India) or SEC(USA) would pay the credit rating agencies to rate bonds. The benefit of it could be that CRAs would not play foul or give false ratings to companies. The disadvantage could be that the reports of the CRAs could be influenced by the opinions of the ruling majority or the government.

How do you think we can solve the loopholes in the credit rating industry? What are the growth opportunities for them? Let us know in the comment section in the marketfeed app available on Android and iOS.