One of the fundamental principles of an economy that allows capital markets to thrive is that businesses need regular financing.
While in an ideal scenario, a business should be able to sustain its costs and growth plans, in the real world, most businesses need to raise capital. This is to meet its operational costs and/or implementing expansion plans.
Companies can raise the required finance by various means. These include issuing shares, applying for a bank loan, trade financing, lines of credit, issuing bonds and fixed deposits.
In the capital market, every investor assesses investment risks differently based on his/her skills for credit evaluation. For the markets to function smoothly and to boost investor confidence, it is important to ensure that the regulators protect the interests of the investors against any malpractices. This leads to the need for credit ratings in the capital markets.
Here is where the credit rating agencies come into play.
A credit rating agency rates the creditworthiness of instruments including corporate bonds, government bonds, certificates of deposit, and other debt instruments that have collateral.
These agencies evaluate the risk of a prospective debtor. This is done by analyzing qualitative and quantitative information about the debtor and predicting their ability to repay the debt. In other words, it assesses the risk of default on a debt that may arise from failure to make the timely payments.
The credit rating provided by these agencies helps in creating a correlation between risk and return of an instrument. Hence, they offer investors a tool to measure the risk of any debt instrument and assess if the returns are worth the risks.
In the absence of a credit rating system, investors tend to perceive the risk of an instrument based on the popularity of the organization issuing it.
Today, we will be talking about the role of credit rating agencies in capital markets.
Companies | Type | Bidding Dates | |
SME | Closes 14 Oct | ||
Regular | Opens 15 Oct | ||
SME | Opens 16 Oct | ||
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Regular | - |
As capital markets evolve, sophisticated products are introduced to offer a range of benefits to investors. While these instruments offered depth to the market, for retail investors the issue is – how safe are these instruments?Â
Most institutional investors have a team of analysts to help them make an informed decision. However, non-institutional investors usually follow the market sentiment. And invest based on the perceived value of the instrument.
Talking about a debt instrument, the primary concern of most investors is if the issuer will honor the payments. Without the right information, making this decision is difficult.
This is where credit rating matters. Credit rating agencies analyze the risk of default as compared to other issuers in the market. Since most investors access the same information, it helps make the system transparent.
Rating agencies conduct a thorough analysis of the macro-level factors like business, operations, technology, industry, market, and economy. This along with the micro-level factors like the company’s market position, quality of management, and cash flows to provide a rating.
Currently, there are seven credit rating agencies in India as per SEBI’s website:
Typically, credit ratings follow a scale of AAA the highest rating to D (lowest). There are eight tiers:
There are four entities that are impacted by a debt instrument:
Credit ratings offer benefits to all these parties. Here is the importance of credit rating agencies in the capital markets.Â
Investors use credit ratings to make investment decisions. They derive the following benefits from them:
The issuing company derives the following benefits from credit ratings:
The financial intermediaries derive the following benefits from credit ratings:
The regulators derive the following benefits from credit ratings:
It is important to remember that credit ratings rely heavily on subjective information and expert’s judgments. Hence, keep the following points in mind before investing:
Happy Investing!