Frequently asked questions on Credit Rating: the complete guide
This article compiles an exhaustive list of FAQs on the concept of Credit Rating.
Frequently asked questions on Credit Rating: the complete guide
Posted on 30 Oct 2022
Author: Sayan Sircar
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13 mins read
FAQ
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This article compiles an exhaustive list of FAQs on the concept of Credit Rating.
FAQ: Credit Rating (24 items)
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What is a credit rating?
Wikipedia defines credit rating as “A credit rating is an evaluation of the credit risk of a prospective debtor, predicting their ability to pay back the debt, and an implicit forecast of the likelihood of the debtor defaulting”. Therefore credit rating is the probability of being able to pay back a loan, both interest over time, and the principal at the end.
Does AAA credit rating mean I will never lose my money?
The AAA (or equivalent) rating indicates the safest possible rating. Since ratings are based on probabilities, there is a non-zero chance, however small, of default. We need to keep in mind that DHFL, which had earlier issued bonds at AAA rating, later defaulted.
Does investing in a AA rated NCD mean I will lose my money?
An AA-rated NCD will have a higher risk of default vs. a AAA-rated one. Whether that risk will materialise or not will depend on the future performance of the issuer and cannot be predicted in advance. The rating agency is supposed to continuously monitor the financial condition of the company for any changes. An investor in high-yield bonds is expected to:
- monitor the credit ratings of the bonds in their portfolio
- be able to recover in case the bond is downgraded
It is therefore important to weigh the risk of default vs. the promise of higher returns.
Does Sovereign credit rating mean I will never lose my money?
Sovereign ratings are issued to the bonds, called gilt, issued by the central government. For an investor in the same country, there is zero credit risk since the government controls the money supply and can print enough currency to pay the interest and principal. Since money printing leads to inflation, the money you will get back at that point will have lower purchasing power.
How does credit rating impact bond returns?
An investor can find out how risky a bond is by looking up its credit rating. Since lower credit risk implies higher risk, then
- lower the credit rating, the higher is the coupon or interest payment and vice versa
- if the coupon payment is quite high, compared to FD or government bonds, then the credit rating is likely lower than AAA
- if the bond does not pay any interest, and the rating is lower than AAA, then it is a case for extra due diligence for the investor
How does rating migration change the price of bonds?
A credit upgrade increases the price of bonds and lowers the yield to maturity (YTM) since it is now more appealing to people since risk of default is now lower. A downgrade does the opposite. We give an example with a 5 year AA rated bond with YTM of 10% and price of 100.
- If the new rating is AAA, the price will raise to say 103.89 and the new YTM will be 9%
- If the new rating is A, the price will fall to say 96.30 and the new YTM will be 11%
You can check this in Excel (on office.com / Google sheets) using the formula PRICE = PRICE(TODAY(),TODAY()+365.25 * 5,10%,YIELD,100,1)
How to use credit ratings to invest in debt mutual funds?
The following debt fund categories use credit ratings as per SEBI:
- Corporate Bond Fund: Minimum 80% investment in corporate bonds only in AA+ and above rated corporate bonds
- Credit Risk Fund: Minimum 65% investment in corporate bonds, only in AA and below rated corporate bonds
- Gilt Fund: Minimum 80% in G-secs, across maturities
- Gilt Fund with 10-year constant Duration: Minimum 80% in G-secs, such that the Macaulay duration of the portfolio is equal to 10 years
Click here to read the related article.
How to use credit ratings to invest in NCDs?
Non-convertible debentures (NCDs) are issued by companies to raise long-term capital from investors. Usually, the minimum entry size is low, like ₹10,000, and there are multiple interest payout options like regular payout or cumulative interest. NCDs are of two main types: secured with company assets and unsecured without any asset backing. The risk is therefore higher when:
- the NCD is unsecured since there is no recourse in case there is a default
- the NCD does not pay interest and gives the entire principal and interest at the end. This is because the company may get into financial trouble later before any interest is paid
It is therefore important to understand the risk implied by the credit rating of the NCD before investing in it. The interest rate of the NCD, which will be prominently demonstrated in advertisements, draw the investor in. It is up to the investor to understand the difference between AAA or AA or lower rated credit rating and invest as per their risk-taking ability.
NCDs generally do not offer a way for investors to exit mid-way without selling the NCD in a stock-exchange. In case there is a credit rating downgrade in the NCD or adverse news from the company, it will be even more difficult to exit the NCD at expected prices.
Is credit rating the same as a credit score?
Credit scores are numbers that are given to individuals denoting their ability to pay back loans or obligations like rent payments. Credit ratings are for companies or governments.
What are the default probabilities used in credit ratings?
In general, long-term credit ratings have default probabilities like:
- A category: less than 0.25% chance of default
- B category investment grade: 0.25%-1-7.5% chance of default
- B category speculative grade: 7.5%-20% chance of default
- C category: 20%-34% chance of default
- D category: in default
It is important to remember that these are probabilities. The table should be used as a way of comparing bonds of similar rating vs. bonds rated differently.
What are the different types of credit ratings?
Credit ratings are of two major types:
- based on the duration of the rating: short-term and long-term
- based on creditworthiness which uses a letter-based scale
Based on the creditworthiness, ratings can be used to classify bonds as:
- investment or prime-grade or high-grade (usually A category)
- speculative or non-prime grade or high-yield (usually lower than A category)
Investment managers use the above classification for choosing debt instruments. For example, a pension fund may be restricted to investing only in high-grade bonds. A credit-risk debt mutual fund, as per SEBI definition, will specifically invest in lower-rated bonds as a high-risk/high-return bet.
What are the responsibilities of a credit rating agency?
A credit rating agency (CRA) has to
- objectively rate the issuer to issue a credit rating based on the financial position of the issuer
- regularly monitor the issuer and the issued bond to ensure that the rating is up-to-date vs. any changes in the financial position of the issuer
- maintain records and disclose any conflict of interest with the debt issuer to ensure that the rating represents the reality of the financial position of the issuer
The CRA rates both the issuer and each individual bond offering of the issuer. The rating might be different for the bond, vis-à-vis the issuer since the bond might have terms and conditions that are different from that of the issuer. A good example of this divergence is when the bond is secured against a lower quality of assets compared to the balance sheet of the issuer.
What do A1+ rated bonds mean in the portfolio of a money market debt fund?
A1+ is the highest credit rating in the money market. Commercial papers, which form an important part of the portfolio of a money market fund, should be A1+ rated. If your fund has papers lower than this rating, maybe due to a downgrade, then you should check if the new risk profile of the fund still matches your own risk-taking ability.
What do the different credit ratings mean?
In general, long-term creditworthiness is measured as:
- A category: AAA / AAa / A1+ or similar has the best credit quality with the least chance of default. This category has subsequent lower ratings like AA, A etc.
- B category: BBB / Baaa or similar has the next best credit quality and a higher chance of default vs. the A tier
- C category: CCC / Caaa or similar has the next best credit quality and a higher chance of default vs. the B tier
- D category: D / RD / SD similar means that these bonds are in default
What is a credit rating downgrade?
A rating downgrade happens when certain material facts about the financial position of the issuer or the bond deteriorate. The rating agency will then move the rating down to reflect the new position of the issuer. Credit rating downgrades may make a previously high-grade bond become high-yield. This event may bring in more money from investors looking at high-yield investments. Investors who specifically want lower-credit quality exposure may choose to enter the bond. A downgrade usually makes it difficult to exit the bond without selling it at lower prices.
What is a credit rating upgrade?
A rating upgrade happens when certain material facts about the financial position of the issuer or the bond improve. Maybe the issuer managed to raise fresh capital to pay down it’s debt or something similar happened. The rating agency will then move the rating up to reflect the new position of the issuer. Credit rating upgrades may make a previously high-yield bond become high-grade. This event may bring in more money from investors looking at high-grade investments. Investors who specifically want lower-credit quality exposure may choose to exit the bond. An upgrade should therefore improve the liquidity of the bond in the secondary market.
What is a credit rating outlook?
When a credit rating agency produces a rating, it also mentions the outlook. The outlook tells investors about the expected direction of movement of the rating in the next six months to two years. The outlook can be:
- positive outlook which means that there is a high chance of improvement in the rating
- stable outlook which means that there is a low chance of change in the rating
- negative outlook which means that there is a high chance of deterioration in the rating
What is credit rating watch?
A credit rating watch means that the rating agency is expecting some changes in the rating in the near future. Watch values can be:
- positive watch: where the rating is expected to improve
- developing watch: where the rating is expected to remain the same
- negative watch: where the rating is expected to deteriorate
Investors should track the watch to check that the bond goes in the direction they are happy with. A watch, unlike a credit rating outlook, will affect all bonds of an issuer and will also get resolved faster.
What is the default of debt issuer?
A default is a delay or failure to repay the interest or principal. If the issuer is in default, they are immediately issued the lowest possible credit rating.
What is sovereign credit rating issued by external rating agencies?
Credit rating agencies rate countries as well. Since the credit rating audience is a global investor, different countries end up in different positions on the rating scale. For an investor inside the country investing in government bonds in local currency, there is no credit risk. But for the global investor, there is foreign exchange risk in case the financial position of the country deteriorates.
Which are the major credit rating agencies?
In India, the major credit rating agencies, in alphabetical order, are
- Credit Analysis & Research (CARE)
- Credit Rating Information Services of India Limited (CRISIL)
- Fitch India
- Investment Information and Credit Rating Agency of India Limited (ICRA)
There are a few more as well. In the US, there are the so-called “Big Three” agencies:
- Moody’s Investors Service
- Standard & Poor’s (S&P)
- Fitch Ratings
Who gives credit ratings?
Credit ratings are issued by credit rating agencies (CRA). These are profit-making companies whose function is to provide a credit rating to a company, state / municipal government or countries that issue bonds or take loans. CRAs are paid by the company they are rating. This last point may lead to a conflict of interest since the issuer might wish to influence the rating they are expected to get through unfair means. The CRA does not rate individual borrowers like you and me.
Who regulates a credit rating agency?
A credit rating agency is regulated by the country’s capital market regulator. In India, the regulator is the Securities and Exchange Board of India (SEBI). SEBI has the power to cancel the license of the rating agency in case it finds any wrongdoing as it did in the case of Brickworks.
Why should an investor look at credit rating?
If you lend money to someone, a credit rating tells you about the chance that you may not get your money back. Debt issuers i.e. those who borrow money, are grouped into groups with each group with a similar risk of default.
Related Articles
- How to choose a debt mutual fund?
- How to understand the portfolio composition of a debt mutual fund?
- How to use the SEBI Potential Risk Class matrix to understand risk in debt mutual funds?
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