Credit ratings give investors a quick, professional and low-cost view of default risk, widen the investor base and help regulators and portfolio managers. Their weaknesses are that a rating is guidance rather than a recommendation, it rests on information and assumptions from the issuer, companies can shop for a better rating, the issuer usually pays the agency, and ratings can lag behind reality, as the IL&FS default in 2018 showed.
A credit rating tells a lender or investor the probability of the subject being able to pay back a loan. However, in recent years, credit ratings have also been used to adjust insurance premiums, determine employment eligibility, and establish the amount of a utility or leasing deposit.
It also assists to the institutional investors regarding the framing of public policy guidelines. and they provide a sound basis for proper risk-return structure.
Advantages of Credit Rating
Credit rating offers various types of benefits:
1. Information Service
Credit rating information allows for the communication of the relative ranking of the default loss probability for a given fixed-income investment in comparison with other related instruments.
Read more: Features of securitization of debt.
The credit rating system allows for the recognition of risk perception by the common investor vis a vis debt instruments and makes the investors familiar with the risk profile of debt instruments.
2. Systematic Risk Evaluation
For the efficient allocation of resources, a systematic risk evaluation is an essential requirement.
Credit rating helps the corporate issuer of a debt instrument to offer every prospective investor the opportunity to undertake a detailed risk evaluation.
It helps a heterogeneous group of investors to arrive at a meaningful and consistent conclusion regarding the relative credit quality of the instrument, especially when they do not possess the requisite skills of credit evaluation.
3. Professional Competency
A credit rating agency, equipped with the required skills, competencies, and credibility, provides a professional service, making it possible to use well researched and scientifically analyzed opinions regarding the relative ranking of different debt instruments according to their credit quality.
4. Easy to Understand
Credit ratings are symbolic and are therefore easy to understand, The rating seeks to establish a link between risk and return.
Investors use the rating to assess the risk level of the instrument by making a comparison of the offered rate of return with the expected rate of return (for the particular level of risk) with a view to opting for the risk-return preferences.
5. Low Cost
The credit rating, as provided by a professional credit agency, is of significance not just for the individuals/small investor, but also for an organized institutional investor.
It provides a low-cost supplement to them in the house appraisal system.
6. Efficient Portfolio Management
large investors may use the credit rating for portfolio diversification by selecting appropriate instruments from a broad spectrum of investment options.
Such investors could use the information provided by rating agencies, by carefully watching upgrades and downgrades and altering their portfolio mix by operating in the secondary market.
7. Index of Faith
Credit rating acts as an ideal index of faith placed by the market in the issuers.
This eventually also acts as a guide for investment decisions.
8. Wider Investor Base
Credit rating offers the advantage of a wider investor base as compared to unrated securities.
Rating arms a large section of investors with specific skills to analyze every investment opportunity and helps them make a very considered decision about their investment.
What Factors Determine the Credit Rating of a Business?
9. Benchmark
The opinion of a credit rating agency enjoys wide investor confidence.
This could enable the issuers of highly-rated instruments to access the market even in adverse market conditions.
Moreover, a credit rating provides a basis for determining the additional return (over and above a risk-free return), which required by investors as compensation for the additional risk borne by them.
This could be a useful benchmark for issue pricing as well.
The differential in pricing could lead to significant cost savings for highly-rated instruments.
10. Efficient Practice
Credit rating serves as an effective tool for merchant bankers and other capital market intermediaries in the process of planning, pricing, underwriting, and placement of issues.
12 Variables Considered in Methodology of Credit Rating.
11. Effective Monitoring
Stock exchange intermediaries like brokers and dealers could use ratings as input for monitoring their risk exposure.
Regulators in some countries specify capital adequacy rules linked to the credit rating of securities in a portfolio.
Merchant bankers also use credit rating for proper packaging issues through asset securitization/structured obligations.
12. To Regulators
Credit rating has facilitated regulatory authorities around the world to issue mandatory rating requirements.
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13. Other Benefits
The investor community, in general, also benefits from the other services offered by credit rating agencies, namely, research in the form of industry reports, corporate reports, seminars, and open assess to the analysis of the agencies.
Disadvantages of Credit Rating
Following are cons of the credit rating:
1. Guidance, not Recommendation
The credit rating process attempts to provide mere guidance to investors/creditors in determining the level of default risk associated with the instrument/credit obligation.
It does not attempt to provide a recommendation, nor does it take into account such factors as market prices and personal risk-reward preferences, in influencing investment decisions.
2. Based on Assumptions
The process of credit rating is basically assumptions based. It does not offer any performance audit to assess the performance of a firm.
In fact, a credit rating grade is assigned solely on the basis of the information provided by the issuer.
Therefore, the quality of grading is likely to be affected by inactive information provided by the issuer.
3. Competitive Ratings
If a firm believes it will not get a good grade from one agency, it may shop around for a more favourable rating.
This is quite possible especially due to competition between relatively large numbers of players in the credit rating business.
4. Conflict of Interest (Issuer Pays)
In most cases the company being rated pays the rating agency. This creates pressure to keep ratings high so the client stays happy. The 2008 global financial crisis showed the risk: thousands of US mortgage securities rated AAA had to be downgraded to junk within months.
5. Ratings Can Lag Behind Reality
Ratings are reviewed periodically, so they may not change until problems are already public. In India, IL&FS group debt carried top ratings until shortly before the group defaulted in 2018, after which agencies cut ratings by several notches in a few days and SEBI took action against the agencies involved.
In India, rating agencies are regulated by SEBI under the Credit Rating Agencies Regulations, 1999. Investors should treat a rating as one input and still read the issuer’s financial statements and the agency’s rationale.
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