Definition: A credit rating is a ranking or prediction of the debt repayment ability (credit risk) of an individual, business, or government. In other words, a credit rating is a measure that informs a lender about the creditworthiness and loan repayment capacity of a borrower.
The lower the credit rating the more the credit risk and likelihood of a debt default. In such an instance, the lender often charges the borrower a higher interest rate to hedge again default or even declines to lend at all. In contrast, high credit ratings attract more patronage and lower interest rates from lenders.
Credit ratings are carried out by an organization known as a credit rating agency (CRA). The rating is usually based on qualitative and quantitative information provided by the individual, business or government is rated as well as information sourced independently by the rating agency.
Content: Credit Rating
Credit Rating Characteristics
- CRAs usually rate on-demand
- Ratings are statements of opinion and not statements of fact
- Determined by a combination of factors
- They focus mainly on mitigation of uncertainty and risk
- The ratings can be rejected or appealed
- Can involve more than one rating agency
- Ratings are made public
- The rating process can be time-consuming
- Credit ratings are not a measure of asset value
- They do not indicate the suitability of an investment
- Ratings are not permanent but can be upgraded or downgraded as determined by the rating committee
- The credit rating industry is an oligopoly with three CRAs [Moody’s, Standard and Poor’s (S&P), and Fitch] controlling about 95% of the market.
Factors Considered in Credit Rating
- Company’s market position
- Industry risk
- Regulatory environment
- Company’s management insights
- Instrument’s lawful validation
- Company’s debt repayment efficiency
- Business insurance
- Working capital management, etc.
CRAs like Moody’s, S&P, and Fitch assign letter grades such as Aaa, AAA, BA1, B, CA, etc to debt securities such as bonds. This is usually based on the grade of the bond. According to Moody’s, AAA ratings indicate bonds of the highest grade. Bond ratings from BA1 are termed non-investment grade and are therefore high yield or junk bonds. Bonds in the default category for non-payment of principal and/or interest are rated C.
Credit Rating Objectives
Information Supply: Credit ratings are meant to bridge the information gap between lenders and borrowers. The main thrust of such information is to provide a thorough assessment and evaluation of the credit risk or creditworthiness of borrowers.
Decision Making: By providing information to the public, especially lenders, CRAs help them make optimal decisions. Hence, it reduces arbitrary decision-making and guesswork.
Developing Financial Markets: CRAs are vital in ensuring sound, efficient and well developed financial markets. Without them, there is likely to be high numbers of toxic debts and defaults in the system.
Helps to Mitigate Uncertainty and Risk: The information and ratings provided by CRAs help to guard against lending under conditions of uncertainty and higher risk. This makes it more likely for lenders to generate profit and thus meet some of their objectives.
Credit Rating Types
- Bonds and Debenture Rating
- Preference Share Rating
- Equity Rating
- Short-term Instrument Rating
- Medium-term Loan Rating
- Insurance Company Rating
- Bank Rating
- Fixed Deposit Rating
- Borrower Rating
- Sovereign Rating
- Individual Rating
- Structured Obligation
- State Rating
- Country Rating
- Collective Investment Scheme Rating
- Real Estate Buider and Developer Rating
- Chit Fund Rating, etc.
Credit Rating Process
The credit rating process mostly involves the use of either analysts or mathematical models or a combination of both to form opinions about an issuer’s credit risk.
In mathematical credit rating models, the emphasis is on the use of quantitative data to help forecast credit risk. To evaluate the creditworthiness of a financial institution such as a bank includes gathering and scrutinizing quantitative data on the institution’s public financial statements and regulatory filings. Such data can be about variables like asset quality, capital base, profitability, debt stock, and others. However, the mathematical model is favoured by few CRAs.
This model is more widely used than the mathematical approach. It involves the assigning of an analyst [usually assisted by a team of specialists] to an entity for the purpose of scrutinizing and subsequently analyzing the entity’s creditworthiness. In the case of a corporate entity, the analyst sources information from various documents, e.g., published reports.
Information can also be obtained through interviews and dialogue with company management. After the information is gathered, analytical skills are used to assess and evaluate variables such as the company’s financial position, operating performance, policies and including risk management strategies.
Below is an illustration of the analyst driven process as described by Standard and Poor’s:
Credit Rating Functions
- They provide useful insight to the public about the financial position and credit worthiness of individuals, firms and governments.
- CRAs help individuals, companies and governments make decisions on debt instruments.
- The services they provide contribute to the quest for efficient financial systems.
- Information provided by CRAs can help in the formulation of government policies.
- They help quantify risk, which is a difficult concept to measure with precision.
- They are a source of employment for economists, accountants and others.
Advantages of Credit Rating
To the Company
- As noted earlier, a favourable rating will not only make it easier for a company to access credit but also lower the cost of such credit. The higher the rating, the easier the access to credit and the lower the cost of the credit.
- It helps companies to find out their strengths and weaknesses from independent sources, i.e., the CRAs.
- Determining such strengths and weaknesses can help companies strategize in terms of things like capital structure, competition, market share, profitability, etc.
- A good rating can help attract funds which can equally assist the company in a variety of ways.
- A favourable rating can also be a good public relations tool for a company in addition to helping to attract high-quality employees.
To the Investors
- Credit ratings help investors to assess credit risk as well as compare different issuers and debt issues.
- With information from CRAs, lenders are in a better position to make lending decisions.
- It saves lenders the financial resources and time which they would have spent in scrutinizing the creditworthiness of potential borrowers, especially in microcredit.
- It significantly reduces incidents of default due to lack of information.
- CRA-based lending can lead to increased profitability due to certainty of repayments because of lower risk.
- Institutional investors such as mutual funds, pension funds, and banks utilize credit ratings to complement their own credit analysis of debt instruments.
To the Intermediaries
- Ratings by CRAs help other intermediaries to compare notes that can enable them to gauge their own opinions about companies.
- Information sharing between CRAs and financial intermediaries can help bring about a more transparent financial system.
- Intermediaries that are favourably rated by CRAs can experience increased patronage of their services which can translate to more profit.
- A strong rating can also boost the public relations profile of an intermediary.
- Investment bankers use credit ratings as a benchmark for the relative credit risk of various debt issues as well as to fix the initial price for individual debt issues.
To the Economy
- By contributing to the development of the financial system, CRAs also facilitate the smooth and efficient functioning of an economy.
- Information provided by CRAs can be used to make laws and policies aimed at economic growth and development.
- Research and information supplied by CRAs can also help stimulate intellectual discourse.
- CRAs pay tax which governments can reallocate to boost the economy.
- CRAs are employment creators.
- Sovereign credit ratings can impact a country’s currency and can also induce or deter foreign investment.
Disadvantages of Credit Rating
Likelihood of Bias: Though CRAs have strict methodologies that help guard against bias, the likelihood for biased ratings can never be completely ruled out since it is humans who are involved.
Not a Signal for Suitability of Investment: Ratings are, at best, mere conjectures or predictions based on the opinions of experts. Hence they cannot be relied on absolutely when trying to determine the suitability of an investment albeit they help in lending decisions.
Lack of Uniformity: There can be a tendency for the same company to be rated differently by more than one agency. This may be due to variations in the methodologies used by CRAs.
Information Gap: Sometimes, the entity being rated may not disclose all the information needed by the CRA. This can impact the rating negatively.