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 for meeting operational costs and/or implementing expansion plans.
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’s Where Credit Rating Agencies Come Into Play
A credit rating agency rates the creditworthiness of instruments like corporate bonds, government bonds, certificates of deposit, municipal bonds, preferred stock, and other debt obligations that have collateral.
These agencies evaluate the risk of a prospective debtor 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 the debtor failing to make the required 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.
In this article
- Investor Protection – Credit Ratings
- List of Credit Rating Agencies in India
- Role of Credit Ratings in Capital Markets
- Things to Remember Before Making Investment Decisions Using Credit Ratings
Investor Protection – Credit Ratings
As capital markets evolved, sophisticated products were introduced to offer a range of benefits to investors. While these instruments offered depth to the market, the problem posed to regular investors was – how do they ascertain the creditworthiness of a debt investment?
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 terms of the instrument and make the required payments. Without the right information, making this decision based on facts 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, etc. along with the micro-level factors like the company’s market position, quality of management, cash flows, etc. to provide a rating.
List of Credit Rating Agencies in India
Currently, there are five credit rating agencies in India:
- CRISIL (Credit Rating Information Services of India Limited)
- ICRA (Investment Information and Credit Rating Agency of India)
- CARE (Credit Analysis and Research Limited)
- ONICRA (Onida Individual Credit Rating Agency of India)
- SMERA (Small Medium Enterprises Rating Agency Of India Limited)
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.
1. 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 and requires some financial competence too. However, the credit rating provided by these professional agencies ensures that all the important factors are taken into consideration. Hence, investors can rely on these ratings and save a lot of time and effort.
2. 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 offering financing options 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 since investors are not aware of them. However, if a company has a high credit rating, then investors will invest in them even if they have never heard their names before.
3. 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 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.
4. 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 without additional effort or cost.
- Timely action – Credit ratings allow regulators to take timely action against defaulting companies.
As you can see, credit ratings benefit all parties involved in capital markets. However, before making an investment decision based on credit ratings, it is important to keep the following points in mind.
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 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 high.
- 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.
As you can see, the role of credit rating agencies in the financial market is primarily to reduce the asymmetry of information between issuers and investors. An instrument with an investment-grade rating can attract investors from around the globe. Apart from making the markets more transparent, these ratings also help investors make informed decisions.