Published on 26/11/2018 8:54:45 AM | Source: HT Media

What the credit rating of a financial instrument signifies

Posted in Top Stories| #SEBI #Special Report #Wealth

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Earlier this month, the markets regulator Securities and Exchange Board of India issued a circular tightening disclosure norms for credit rating agencies in India. You can read the circular here:

The circular has been issued after the credit rating agencies abruptly downgraded ratings of bonds sold by IL&FS and related entities after they defaulted on payment obligations in September. Credit rating agencies (CRAs) had downgraded the bonds from high investment grade (AA+ in some cases) to default or junk.

The rating agencies will now need to specifically disclose the liquidity position of the company whose financial instrument like a bond is being rated. A company’s liquidity position would include parameters such as liquid investments or cash balances, access to unutilized credit lines, liquidity coverage ratio, and adequacy of cash flows for servicing maturing debt obligation, the Sebi circular said. Additionally, credit rating agencies would also need to disclose if the company is expecting additional funds to reduce its debt along with the name of the entity that will provide the money.

Let’s take a look at what exactly is a credit rating, how it is arrived at and what does it signify.

What is credit rating?

A credit rating is a professional and informed opinion on the creditworthiness of the issuer of a financial instrument. It also indicates the relative degree of risk of timely payment of interest and principal amount on a debt instrument. It indicates the probability of default of the rated financial instrument and therefore provides a benchmark for measuring and pricing credit risk.

Typically, credit ratings for companies and financial instruments are assigned in alphanumeric combinations like AAA or AA+. Typically, instruments rated AAA are considered to have the highest degree of safety regarding timely servicing of financial obligations. Such instruments carry the lowest credit risk. A plus (+) or a minus (-) sign is used to indicate relative position of an instrument in a particular rating category. The ratings also include outlook on the instrument, which is indicated as stable, positive or negative.

The company whose instrument is being rated pays the fee for the rating exercise. This is followed by sharing of information with the rating agencies and discussion with the management of the company. These ratings are based on evaluation of the strengths and weaknesses of the company fundamentals including financials, along with an in-depth study of the industry as well as macro-economic, regulatory and political environment. Hence, if any of the factor changes during the tenure of the instrument, the rating of the instrument could change.

How you should read these ratings

Typically, a company or a financial institution gets a credit rating from more than one credit rating agency. Ideally, the rating for one instrument from different rating agencies should be similar. Moreover, rating agencies also put out a detailed rationale for a particular rating on their websites. As an investor, along with the credit rating, you should also attempt to understand the rationale behind the ratings.

It is important to note that a rating is not a recommendation to buy, sell or hold a debt instrument. Rating only provides an additional input to you and you should do your own independent and objective analysis before arriving at an investment decision. In the case of instruments you don’t understand, it is better to take professional help.