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.
Important of credit rating agencies
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.
Investor Protection – Credit Ratings
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?
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.
List of Credit Rating Agencies in India
Currently, there are seven credit rating agencies in India as per SEBI’s website:
- CRISIL (Credit Rating Information Services of India Limited)
- ICRA (Investment Information and Credit Rating Agency of India)
- CARE (Credit Analysis and Research Limited)
- ACUITE Ratings and Research Ltd
- Brickwork Ratings India Pvt Ltd
- INFOMERICS Valuation and Rating Pvt Ltd
- India Ratings and Research Pvt Ltd
Typically, credit ratings follow a scale of AAA the highest rating to D (lowest). There are eight tiers:
Role of Credit Ratings in Capital Markets
There are four entities that are impacted by a debt instrument:
- The investor
- The issuer
- The financial intermediaries
- The regulator
Credit ratings offer benefits to all these parties. Here is the importance of credit rating agencies in the capital markets.
Benefits of Credit Ratings to Investors
Investors use credit ratings to make investment decisions. They derive the following benefits from them:
- Assistance in decision-making – A quick look at the credit rating of an instrument tells investors about the risks associated with it. This allows them to choose instruments based on their risk tolerance and expected returns.
- Regular reviews of ratings – Credit rating agencies regularly review the ratings to ensure that it is relevant to the existing condition of the issuer and market. Hence, if an investor has purchased an instrument with the highest rating but finds it to be downgraded, then he can decide to sell the instrument to curb his losses.
- Assurance of safety – An instrument with a high credit rating assures investors of the safety of their investment and the financial strength of the issuer.
- Ease of understanding – Credit rating agencies have a standard way of rating instruments. Hence, investors can easily understand the investment proposal.
- Saves time & effort – Analyzing an issuing company’s financial strength can take a lot of effort and time. It requires some financial competence too. However, the credit rating provided by these professional agencies ensures all the important factors are taken into consideration. Hence, investors can rely on these ratings and save a lot of time and effort.
Benefits of Credit Ratings to Issuers
The issuing company derives the following benefits from credit ratings:
- Creates corporate image – For an issuing company, it’s better to have a corporate image based on facts as opposed to perception. Credit ratings ensure that the company gets a true corporate image in the market.
- Can reduce the cost of borrowing – If a company has low risk according to the credit rating agency, then it will give it a high credit rating. This means that investors will buy debt instruments from the company if they are looking at low-risk investments. And will willingly accept lower interest rates. Hence, the issuing company can raise capital at a lower cost.
- More avenues for borrowing – If a company has a good credit rating, then there is no shortage of avenues to approach for raising funds. This is because most organizations raising capital accept credit ratings provided by recognized agencies.
- Helps promote non-popular companies – Many companies are not popular among investors. Hence, when they issue a debt instrument, the reach is limited as investors are not aware. However, if a company has a high credit rating, then investors may invest in them.
Benefits of Credit Ratings to Financial Intermediaries
The financial intermediaries derive the following benefits from credit ratings:
- No need to explain the risk/return of a debt instrument – Credit ratings are self-explanatory and easy to understand. If an investor looks at an instrument with an AAA rating, he expects lower interest rates. And he purchases it if his risk tolerance is low. Hence, stockbrokers and other financial intermediaries don’t have to explain risks or returns to their clients.
- Reduces dependency – Investors can choose instruments based on their investment plan by looking at the credit rating of various instruments. This allows them to be independent and reduces the load on investment advisors.
Benefits of Credit Ratings to Regulators
The regulators derive the following benefits from credit ratings:
- Increases transparency – Credit rating agencies use all possible information on the issuing company (quantitative and qualitative) to assign a credit rating to it. This includes information that is not easily available to regular investors. Hence, it makes the process of investing in such instruments more transparent.
- Creates a differentiation between companies – Credit ratings allow regulators to easily differentiate between performing and non-performing companies.
- Timely action – Credit ratings allow regulators to take timely action against defaulting companies.
Things to Remember Before Making Investment Decisions Using 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:
- Credit ratings are based on the past performance of the company. While ratings are revised to keep them relevant, the frequency of revisions is not frequent.
- An issuing company that has malicious intentions can hide information from the credit rating agency too. Hence, it is not a full-proof way of assessing the company’s reliability.
- Credit agencies rate an instrument and not the company. Hence, you must look at credit ratings of different instruments offered by the same issuer before making a decision.
- There is a possibility of an issuer influencing its rating.
- Different agencies can rate the same instrument differently.