Credit Ratings : All You Want To Know

Author : Deependra Shekhawat

Credit Rating refers to a rating assigned by a Credit Rating Agency to an entity or to a government (country) in respect its issued debt securities like bonds, debentures etc. When credit rating is assigned to a government/country then it is called "Sovereign Credit Rating". Credit rating denotes the ability and willingness of an entity or a government to honor its debt obligations i.e. Interest and Principal. Moody’s, Standard & Poors and Fitch  are the credit rating giants in the world, collectively known as "Big Three" holding almost 95% of global credit rating business. 

It is pertinent to note the nature of rating given, a credit rating is only an opinion expressed by a credit rating agency on the credit worthiness of an entity or a government, involving no recommendation to park his money to the entity or debts so rated.

 There are in general, two types of credit ratings namely, Short term credit rating and Long term credit rating.  Former for securities having maturities upto 12months, later being for residuary terms of maturities.

 Further, Short Term and Long Term Credit Ratings are divided into four categories namely;

(i) High Credit Rating : - A high credit rating for example AAA/Aaa/AA/Aa/A for an entity or a government signifies that, the said entity or the government is the Best Investment Option for the potential investors and the funds invested may well be assumed in safe hands with Lowest Risk to the investors.

(ii) Low Credit Rating - A low credit rating for example BBB/Baa/Ba/BB  for an entity or a government signifies that, the said company or the government may be a Moderate option for the investors to invest their money. Money invested in such entities or governments (Countries) may still be assumed in safe hands with Low Risk to the investors.

(iii) Junk Rating - Junk rating is further divided into two parts. However, their nomenclature is not practically used as such and are broadly identified with the term Junk, assigned here for better understanding only.

(a) Junk Speculative :- Such kind of rating may be denoted by CCC/Ca/CC/C for an entity or a government. An entity or government with such a rating is viewed as a Speculative Investment Option with Highest Risk to the investors.

(b) Junk "In Default" :- Such kind of rating may be denoted by DDD/DD/D for an entity or a government whose payments of debt obligations are in Default. Such a company is generally unable to attract the investors even on higher interest payouts.

(iv) Recovery Rating - A recovery rating is a sub opinion included in "Credit Rating Opinion". Recovery rating is the percentage of potential recovery which an investor can expect to        recover from the issuer of security against his outstanding/unpaid balance in the event of default. A recovery rating may be denoted in numbers like 3,2,1 & 0  where 3 may denote 100% recovery, 2 may denote 80 to 100% recovery 1 may denote 50 to 80% recovery and 0 may denote 0 to 50% recovery say if recovery rating for X Enterprise is 1 then it suggests that a person investing euro 10,000 in 16% debt securities of X Enterprises can expect a maximum refund of euro 5,000 to 8,000 as principal and euro 800 to 1,280 p.a as interest in the event of occurrence of default on part of X Enterprises. However, some of the agencies do include such opinion in their main opinion. Whenever, such a recovery rating is issued to an entity then it is expressed in the main opinion and not as part of a separate opinion. Such a rating is important for an investor evaluating "Non Investment Grade Securities". (Discussed later in this article).

 Sovereign Credit Rating :- When the credit rating is assigned to a government/country then it is called "Sovereign Credit Rating". A Sovereign credit rating signifies the ability and willingness of a government to honor its debt obligations as well as ability of a government to provide a secure investment environment to the potential investors. Such credit rating is a reflection of factors like economic status of a country, political stability, transparency in the capital market, level of public and private investment flows, Foreign Direct Investment (FDI), Foreign Currency Reserve (FCR), ability of an economy to remain stable despite a government change, etc.

It is important to encompass one more dimension of these ratings. Ability and willingness to service periodic payments may be assessed in respect of not only domestic but also foreign currency as well. An entity or a government may be highly rated as regards it ability and willingness to honor its debt obligation in domestic currency while the same entity or government may be low rated/Junk rated when it comes to honor its debt obligation in foreign currency.

 Based on credit ratings, securities are classified into two categories namely;

 (i) Investment Grade Securities: Securities of companies having high credit ratings like AAA are treated as "Investment grade securities.

 (ii) Non Investment Grade Securities/Speculative Grade Securities:  Securities of companies which currently are capable of meeting their debt obligation but are facing future       uncertainties regarding their debt obligations are classified as Non Grade Investment Securities. Entities with credit rating BBB/CCC/DDD may fall under this category based on future uncertainties involved.

What is the significance of high, low and junk Credit Rating for the issuing entity?

Entity or government with high credit rating can seek further debts/loans etc. at comparatively lower interest rates, hence easing availability of funds. Conversely, an entity or a government with low rating has to raise further debts/loans etc. at high interest rates. An entity or a government with junk rating is no longer an appropriate investment alternative.

The Bottom Line- Higher the rating lower is the "Borrowing Costs" or vice versa.

Review of Credit Rating : Once assigned, a credit rating is not the final one and needs to be reviewed every year. Accordingly a credit rating previously issued may be upgraded (i.e. improved) or downgraded (i.e. battered) as per the latest financials of the issuer of security. For eg. Moody's downgraded Sony's rating from B1 to B3 for the FY 2013 - 2014 and it (Moody's) opined that, Sony had to do a lot with its "Battered Balance Sheet" of FY 2012 - 2013 but they failed to improve their Balance Sheet and therefore, we (Moody’s) have no choice except to downgrade their rating to junk level. The rating agencies are required to publish the revised ratings on their websites.

Independence of Credit Rating Agencies has also attracted lot of negative response. A section of intelligentsia blames credit rating agencies for global crisis of 2008, for they assigned high credit rating to entities which ended up being bankrupt subsequently.

The Judgment given by Federal Court of Australia finding the rating as "false" or "negligent misrepresentation”, resulted in 4% and 3%  decline in share price of Standards & Poors and Moody's respectively in New York Trading. However, it should be noted that, credit rating agencies may be held liable for "Inaccurate Ratings" and not for their "Expression of Opinion.