Credit Rating: Meaning, Importance, Credit Rating Scales

A credit rating is an evaluation of a borrower’s creditworthiness, typically an organisation or the government. It assesses the likelihood of the borrower repaying the debt in full on time. It is performed by independent agencies known as credit rating agencies. Credit ratings are a valuable tool for lenders and investors as it helps them make informed financial decisions. In this article, let’s delve into credit rating and its importance.

What are Credit Ratings?

A credit rating is a vital evaluation of an individual’s or an entity’s creditworthiness, reflecting their ability to repay debts and meet financial obligations. Credit rating agencies conduct these assessments, providing an analysis of credit risk. 

They assist in evaluating the risk linked to entities such as corporations, the government, etc., when you opt to lend them money through fixed-income instruments. This risk is known as credit risk and frequently plays a pivotal role in selecting appropriate debt instruments for investment.

Various credit rating agencies assign credit ratings, ranging from AAA to D, based on creditworthiness. ‘AAA’ represents the highest rating. A higher credit rating implies a higher probability of the entity repaying the loan.

Credit ratings play a crucial role in helping investors evaluate the creditworthiness of borrowers. The ratings are important to both borrowers and lenders. 

Users of Credit Rating

The following entities and organisations use the credit ratings issued by credit rating agencies.

• Investors: Individual and institutional investors that invest in bonds and shares of a company often check the credit rating before investing. This is to determine the returns based on the company’s credit rating. If the credit ratings are high, the returns will be healthy over a long period of time.
• Lenders: Lenders check the credit rating of a company before lending money. The primary reason behind this is to determine the repayment capacity and creditworthiness of the borrower. A high credit rating indicates the company has healthy repayment behaviour, whereas a low credit rating indicates the company may not repay the dues on time.
• Intermediaries: Investment banks check the credit ratings of securities to evaluate the credit risk before underwriting the securities. Moreover, they also decide the price of the security based on the credit rating.
• Other businesses: During mergers, joint ventures, and partnerships, other businesses check the credit rating to evaluate the counterparty risk.

Types of Credit Rating

Credit ratings are broadly classified into two categories, namely investment grade and speculative. Although the terminology differs across rating agencies, the underlying meaning of the rating remains the same.

• Investment grade: Companies with investment-grade ratings are considered financially stable. They are more likely to repay dues to borrowers on time and hence are considered low risk. Companies with this rating usually get loans at low-interest rates.
• Speculative grade: Companies with a speculative grade rating are usually considered high-risk investments. This is because they might have financial challenges that affect their repayment ability or may be burdened with a lot of debt. Hence, these companies offer a high interest to the investors and to compensate for the high risk associated with them.

What is a Credit Rating Agency?

A credit rating agency (CRA) is responsible for evaluating the creditworthiness of individuals or companies. These agencies assess the debtor’s income and credit lines to analyse their capacity to repay debt and identify associated credit risks.

The Securities and Exchange Board of India (SEBI) has the authority to authorise and regulate credit rating agencies per the SEBI Regulations of 1999 under the SEBI Act of 1992.

The following are the credit rating agencies in India:

Credit Rating Information Services of India Ltd. (CRISIL)

Established in 1987, Credit Rating Information Services of India Limited (CRISIL) is among the oldest credit rating agencies. CRISIL offers corporate and sovereign credit ratings and short-term instrument ratings and has been engaged in infrastructure ratings since 2016. It’s an S&P Global group company.

Investment Information and Credit Rating Agency of India (ICRA) Ltd.

Established in 1991, the Investment Information and Credit Rating Agency (ICRA) is a collaborative effort between Moody’s and the Indian Financial and Banking Service Organisation. This independent agency provides professional investment information and credit ratings.

Credit Analysis and Research (CARE) Ltd.

Operational since April 1993, Credit Analysis and Research Limited (CARE) is a seasoned credit rating agency assisting corporates in raising funds and aiding investors in decision-making based on credit risk and risk-return expectations. 

India Ratings and Research Pvt. Ltd.

India Ratings and Research (Ind-Ra), a wholly-owned subsidiary of the Fitch Group headquartered in Mumbai, delivers precise and timely credit opinions on the country’s credit market. It operates PAN India, providing essential credit rating services to banks, insurance companies, and various financial entities.

Brickwork Ratings India Private Ltd.

Registered under SEBI and accredited by RBI, Brickwork Ratings (BWR) is a leading Credit Rating Agency. It is empanelled by NSIC and holds accreditation from NABARD for NGO and MFI grading. Canara Bank is a promoter and partner of BWR.

INFOMERICS Valuation and Rating Private Ltd.

Former bankers, finance professionals, and administrative services personnel founded INFOMERICS Valuation and Rating Private Limited, a SEBI-registered and RBI-accredited Credit Rating Agency.

Acuité Ratings & Research Ltd. Erstwhile SMERA Ratings Ltd.

Acuité Ratings & Research Limited is a SEBI-registered and RBI-accredited credit rating agency specialising in providing ratings to companies in structured finance, corporate, and financial sectors.

How Does a Credit Rating Agency Work?

Each credit rating agency employs its unique algorithm to assess credit ratings using key factors such as prompt repayment of obligations, cash flow, working capital, and net worth. 

On a monthly basis, these agencies gather credit information from partner banks and other financial institutions. 

Upon receiving a credit rating request, the agencies extract relevant information to compile a comprehensive report based on these factors. Companies are then assigned a credit rating based on this report.

Banks, financial institutions, and investors rely on these credit ratings to decide on investment opportunities and bond purchases.

A low credit rating suggests a higher risk of default and vice versa.

What are the Credit Rating Scales?

Every credit rating agency has a credit rating scale based on which it rates the companies and their financial instruments. The credit rating scale is usually depicted in alphabetical order and ranges from high rating to low rating. The rating usually starts from AAA and goes on to D, with AAA being the highest rating and D being the lowest. A high credit rating indicates a low risk of default, whereas a low credit rating indicates a high risk of default. Moreover, instruments with high credit ratings pay a low interest as the risk factor is low, and instruments with low credit ratings pay a high interest to compensate for the high risk.

Rating agencies have different nomenclature for different categories of instruments. The following are the different categories:

• Long-term credit rating: Long-term credit rating is assigned to long-term financial instruments such as bonds, debentures, bank loans, and other fund-based facilities with a maturity of more than one year.
• Short-term credit rating: Short-term credit rating is assigned to commercial papers, short-term debentures, certificates of deposit, and working capital borrowings.
• Structured obligations (SO): Ratings given to both long and short-term financial instruments that are structured in nature and have a suffix ‘SO’ written against the rating. ‘SO’ ratings are given only to securitised or asset-backed instruments. 
• Credit enhancement: This rating is given to both long-term and short-term financial instruments that are backed by explicit credit enhancement that is external. They usually have a suffix of ‘CE’ against the credit rating.

For all the above categories, the rating will range between AAA and D. However, there will be a suffix attached to this rating indicating the rating category.

Long Term Credit Rating Scale: In Detail

Credit ratings of AAA to BBB are categorised as investment grade, whereas BB to D is categorised as speculative-grade ratings.

What are the +/- in the ratings?

For eg. A+ rating is given when a security is ranked slightly higher than the credit rating scale of A but is ranked below AA. Similarly, A- rating is given when a security is ranked below A, but ranks higher than BBB. Every credit rating scale has a ‘+’ or ‘-’ which is given at the discretion of the credit rating agency. 

Short Term Credit Rating Scale: In Detail

Short term credit rating is given to securities with maturity of one year or below. The credit rating ranges between A1 and A4 and D. 

In Short Term ratings, there are only ‘+’ ratings and no ‘-’ ratings.

Factors Affecting Credit Rating in India

Credit ratings in India are influenced by various key factors that collectively offer insights into the company’s financial health and creditworthiness. The factors that affect credit ratings in India are:

• Repayment behaviour: Timely repayment of previous loans positively impacts creditworthiness. Any late payments or defaults can negatively affect credit ratings.
• Loan Portfolio: If the loan portfolio comprises secure loans, it’s a positive sign for a better credit rating. On the other hand, if a company loan portfolio is majorly made up of unsecured loans, it may negatively impact the credit ratings.
• Market Reputation: A positive market reputation contributes to higher income and better repayment capability, enhancing credit ratings. Conversely, a negative reputation may lead to a lower rating.
• Future Business Prospects: The growth potential and projected earnings of a business significantly influence credit ratings. Strong expansion plans and a promising outlook result in higher ratings, while uncertainty or a lack of growth prospects may lead to lower ratings.

What Happens When There is an Upgrade or Downgrade of Credit Rating?

Credit ratings aren’t permanent. They keep changing with changes in the issuer’s financial performance. When an instrument’s credit rating increases, it is called an upgrade; if it decreases, it is called a downgrade. The credit rating of a company is upgraded if its ability to repay loans has increased. Alternatively, the credit rating is downgraded if its ability to repay loans has decreased.

If the credit rating is upgraded, the instrument’s price goes up, and the yield goes down. This is because investors are willing to accept a lower return for a high-rated instrument. In contrast, if the credit rating is downgraded, the price goes down, and the yield goes up. This is because the investors want to be compensated for the additional risk they are willing to take.

Conclusion

Credit rating is an important indicator for investors. It is based on credit rating, and you can decide whether to invest or not. A high credit rating is considered safe when compared to a low credit rating. However, the returns from a high-rated instrument are lower than a low-rated instrument. If you prefer low risk over returns, then highly rated instruments can be considered. However, if you prefer returns over risk, then you can consider low-rated instruments.

Frequently Asked Questions (FAQs)

What is the difference between credit rating and credit score?

Credit ratings are assigned to companies and instruments based on their financial performance and ability to repay debts. Credit score, on the other hand, is assigned to individuals based on their credit history. Credit ratings are alphabetical codes that range from AAA to D, whereas credit score is a numerical value that ranges between 300-900. Investors, lenders, intermediaries, and other companies use credit ratings, whereas only banks and other financial institutions use an individual’s credit score.

What is the meaning of ‘outlook’ in the credit rating?

A rating outlook in a credit rating indicates the direction in which the credit rating is likely to move in the medium term. Outlook is determined by the possible alternate scenarios and their impact on a company’s creditworthiness. The rating outlook is either ‘positive’, ‘stable’, or ‘negative’. A positive outlook indicates that the rating can be upgraded in the medium term. A stable outlook means the rating will remain unchanged, and a negative outlook indicates the rating can be downgraded in the medium term.

Why are credit ratings relevant?

Credit ratings aren’t permanent. They keep changing with the financial performance of the company. Once a credit rating is assigned to an instrument, it is reviewed continuously until maturity. Credit rating agencies either upgrade or downgrade the rating based on the company’s ability to repay its dues. Hence, credit ratings are considered relevant and can be relied upon before making an investment decision.

What are the top 4 credit rating agencies?

The top four  credit rating agencies in India are CRISIL, ICRA, CARE & India Ratings. However, other rating agencies also rate companies and instruments, and they are Brickwork Ratings, Infomerics Valuation, and Acuité Ratings.

How is credit rating calculated?

Credit rating is determined after considering several factors, such as prompt repayment of obligations, cashflows, working capital, net worth, operational performance, debt metrics, valuation, liquidity, and future prospects.