What is Credit Rating in Capital Markets? How is it Relevant to You?

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When you order food from a restaurant, you look at the star rating and the reviews left by others on the quality of the service from the restaurant, right? Why do you do that? Because that may give you a sense of how good the place is, if the price of the dishes is justified, if the quantity of food served is enough and also sometimes give you an indication of which dishes are the best in the restaurant.

Credit Rating is something like that scoring system but it is a system used typically for businesses that are seeking credit on the stock market, by selling debt securities. For example, let’s say you want to buy a bond of Company X. You may look at the credit rating of Company X and decide – based on their score – whether you feel like they are going to be reliable in paying you back or not. You most likely will not invest if the score gives you the impression that Company X may default on repayment.

What do credit rating companies do? Are they different from those that issue a credit score?

Credit rating companies do the scoring for you. A credit rating company evaluates the financial health of the company with the goal of identifying the level of its ability to make good on it’s debts. Credit rating companies let you – as an investor – know whether you should invest in a certain debt security via a score assigned to the company – or any debt issuer – floating the debt security on the stock market.

As you know debt, also known as bonds, refers to a loan given by the investor to the debt issuer. The bond document comes with a maturity date and often also with a fixed rate of interest. The credit rating of the bond-issuer tells you what the credit rating company found out about their ability to pay back both your principal amount (that is your investment capital) and the agreed interest.

Credit rating is to businesses what credit score is to you. For example, when you want a loan or a credit card, you approach a bank or NBFC. One of the first things they will ask for – even before your income or occupation – is usually your credit score. That’s because it matters to them that even if you make Rs 5 lakh per month, if you habitually default on your payments.

Your credit score tells the lending institution about your ability and likelihood to pay them back. Similarly, a credit rating tells you about a debt-issuer’s abilities and track record when it comes to settling its debts.

Another difference between the two is that credit rating is generally three alphabets, optionally followed by a plus or a minus, with AAA+ being the highest rating (such as that of US Government Bonds). Generally, AAA and AA (high credit quality) and A and BBB (medium credit quality) are considered investment-grade. Credit ratings below these levels (BB, B, CCC etc.) are considered low credit quality, and are commonly referred to as junk bonds. Credit score in India, meanwhile, is measured as 1 to 999. A credit score of above 750 is considered a good score for creditworthiness.

When must investors obtain a credit rating?

Investors must check the credit rating of any debt issuer whom they intend to invest with. The debt issuer can be a country or a central government, a state government, a municipality, a corporation or even an NGO.

Basically, before buying a bond from any government body or company or organisation, it is advisable for investors to check the bond-issuer’s credit rating.

When opting for a bond, you should compare the credit rating of similar companies. Let’s say company X and company Y have a rating of AAA and BBB respectively, and are issuing corporate bonds, the investor will be more likely to safeguard their money if they opt for company X.

Debt issuers with a low credit rating may try to market themselves with a promise of higher rate of return to attract investors. Investors need to weigh the risk-reward benefits before investing in such big promises – small credit rating investment propositions.

Credit rating agencies in India

Investors should not rely on the bond-issuer’s own declaration of their credit rating unless they have been evaluated by one of the country’s leading credit rating companies.

Every company has to compulsorily get themselves credit rated before floating any debt securities or bonds on the stock market. This is a SEBI mandate aimed at protecting you – the investor.

Here are the names of the top 7 credit rating agencies in India:

– Brickwork Ratings

– CRISIL

– CARE

– ICRA

– India Ratings and Research

– Infometrics Valuation and Ratings

– SMERA Ratings

These agencies are SEBI-registered and are, therefore, authorised by the regulator to provide accurate and unbiased credit ratings. It is advisable to only rely on credit ratings supplied by these companies.

Be cautious

Even companies that display a high credit rating could default on a debt repayment. Something fundamental could have completely changed the game: A crisis could have come along; a new player might disrupt the market; raw materials might become more costly; demand might drop due to some external issue like unemployment.

Remember that although bonds are low-risk investments and a good credit rating bodes well for your investment in a certain bond, there is still a degree of risk – this is true for all investments, although each investment will be risky to varying degrees.

Conclusion

it is definitely advisable to get a credit rating for a company and its peer group before making an investment. However, while this is a safety precaution, it is not a 100% guarantee that the bond issuer will indeed return the capital with the agreed sum of interest by the agreed date.

Consider your risk appetite before investing even when you have a positive credit rating in hand.