Meaning of ratings
· Ratings are evaluation of an issuing company’s ability to repay principal and interest.
· The ratings are expressed in code numbers which can be easily comprehended by even the lay investors.
In the world of technically complex trading, the ratings are the quickest way of understanding a company’s financial standing.
The ratings of different debt instruments of same company may be different.
What is credit rating?
· A credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government.
· Credit ratings are calculated from financial history and current assets and liabilities.
· The credit rating is used by individuals and entities that purchase the bonds issued by companies and governments to determine the likelihood that the government will pay its bond obligations.
· A poor credit rating indicates a credit rating agency's opinion that the company or government has a high risk of defaulting, based on the agency's analysis of the entity's history and analysis of long term economic prospects.
· Ratings, usually expressed in alphabetical [AAA,BB etc.] or alphanumeric [BB+,BBB-] symbols.
Importance of credit rating.
· Credit rating establish a link between risk and return.
· An investor uses credit rating to assess the risk level and compares the offered rate of return with his expected rate of return.
· One needs to manage healthy credit rating especially if he is planning to borrow a loan or invest in shares.
· A low credit rating is considered as a sign if high risk of non payment of debt and low returns.
· It is important at country level also as many countries rely on foreign investors to purchase their debt, and those investors heavily rely on credit rating.
· If the credit rating of a country is good then it would b able to access funds from outside their country and attract other forms of investment such as foreign direct investment.
Why do credit ratings change?
· The reasons for ratings adjustments vary, and may be broadly related to overall shifts in the economy or business environment or more narrowly focused on circumstances affecting a specific industry, entity, or individual debt issue.
· In some cases, changes in the business climate can affect the credit risk of a wide array of issuers and securities.
· For instance, new competition or technology, beyond what might have been expected and factored into the ratings, may hurt a company's expected earnings performance, which could lead to one or more rating downgrades over time.
· While some risk factors tend to affect all issuers—an example would be growing inflation that affects interest rate levels and the cost of capital—other risk factors may pertain only to a narrow group of issuers and debt issues
Application of credit rating
Credit rating is applied on :
Bonds :Ratings play a critical role in determining how much companies and other entities that issue debt, including sovereign governments, have to pay to access credit markets, i.e., the amount of interest they pay on their issued debt.The threshold between investment-grade and speculative-grade ratings has important market implications for issuers' borrowing costs.
Bonds that are not rated as investment-grade bonds are known as high yield bonds or more derisively as junk bonds.