If you invest in bonds, notes, or other debt instruments, you have probably come across credit ratings. these credit ratings usually appear in the form of alphabetical letter grades (for example, ‘AAA’ and ‘BBB’) and are intended to give you an estimation of the relative level of credit risk of a bond or a company or government as a whole. Credit ratings can be a useful item of information to consider when evaluating an investment along with other information. But if you use credit ratings, you should understand their limitations. You should not base your investment decision solely on a credit rating or treat a credit rating as if it were investment advice.
Benefits of Credit Rating to Company:
Lower cost of borrowing: A company with highly rated instrument has the opportunity to reduce the cost of borrowing from the public by quoting lesser interest on fixed deposits or debentures or bonds as the investors with low risk preference would come forward to invest in safe securities though yielding marginally lower rate of return.
Wider audience for borrowing: A company with a highly rated instrument can approach the investors extensively for the resource mobilisation using the press media. Investors in different strata of the society could be attracted by higher rated instrument as the investors understands the degree of certainty about timely payment of interest and principal on a debt instrument with better rating.
Rating as marketing tool: Companies with rated instrument improve their own image and avail of the rating as a marketing tool to create better image in dealing with its customers feel confident in the utility products manufactured by the companies carrying higher rating for their credit instruments.
Reduction of cost in public issues: A company with higher rated instrument is able to attract the investors and with least efforts can raise funds. Thus, the rated company can economise and minimise cost of public issues by controlling expenses on media coverage, conferences and other publicity stunts and gimmicks. Rating facilitates best pricing and timing of issues.
Motivation for growth: Rating provides motivation to the company for growth as the promoters feel confident in their own efforts and are encouraged to undertake expansion of their operations or new projects.
With better image created though higher credit rating the company can mobilise funds from public and instructions or banks from self assessment of its own status which is subject to self-discipline and self-improvement, it can perceive and avoid sickness.
Unknown issuer: Credit rating provides recognition to a relatively unknown issuer while entering into the market through wider investor base who rely on rating grade rather than on ‘name recognition’.
Benefits to brokers and financial intermediaries: Highly rated instruments put the brokers at an advantage to make less effort in studying the company’s credit position to convince their clients to select an investment proposal.
This enables brokers and other financial intermediaries to save time, energy, costs and manpower in convincing their clients about investment in any particular instrument.
Why do Investors use Credit Ratings?
- When making investment decisions, credit ratings and any related rating and industry trend reports can be helpful tools, provided you use them appropriately. Credit ratings may offer an alternative point of view to your own financial analysis or that of your financial adviser.
- Credit ratings may enable you to compare risks among investments in your portfolio. Considering the credit ratings of multiple credit rating agencies may be useful because they may offer diverse views on the creditworthiness of an investment
- In general, if you use credit ratings, they should be a supplement to, and not a replacement for, your own research, analysis, and judgment to determine whether an investment best satisfies your needs. remember that credit ratings address credit risk only; they do not address other risks such as liquidity risk, interest rate or market risk, or prepayment risk.
- NRSROs are required each year to post on their websites performance statistics and the history of their credit ratings for their registered rating classes. The performance statistics show transition and default rates for the classes of ratings. Investors can also use these statistics to assess the stability, or volatility, of credit ratings within and among fixed income sectors.