The Importance of Credit Rating

1. What is a credit rating?

Credit rating agencies provide value for investors and market participants by rating the creditworthiness and ability of different entities to repay their credit and debt obligations. By providing a rating, credit agencies put the different entities they rate on an equal footing, providing a comparable rating for different types of entities and different types of bonds. Credit rating agencies provide ratings to sovereign, provincial, and municipal governments, corporations, and credit and fixed income products and investments such as Asset-Backed Securities (ABS). An entity can receive ratings for both its own creditworthiness and that of the different bonds and notes it issues. An entity rating gives an opinion of the creditworthiness of the entity overall, while a rating of a bond rates the risk of a particular bond issue. The two can be different depending on a variety of factors.

The rating is the opinion of the agency for how likely it is that a credit product will be repaid. Often, a rating is associated with a probability of default, with higher probabilities of default associated with lower ratings. A credit rating can also be associated with expected losses, with lower ratings associated with higher expected losses should the bond default. Entities and bond issuances with similar ratings have the same risk level, and thus credit rating is a way for investors to pick instruments with risk appetite that they are comfortable with.

A credit rating takes into account many factors, including but not limited to: the financial health of the entity; cash flows (whether positive or negative); specific bond issue covenants that may be relevant to the bond; lien priority; entity governance issues; past history of debt repayment; bond term; and future economic outlook relevant to the entity.

It is important to note that non-financial issues play an important role in determining credit ratings. The perceived competence of management may be assessed through their meeting with the rating agency. If the rating agency perceives problems in how the entity is run, such issues will inform their ratings. This point is exemplified by S&P’s decision to downgrade the United States federal government’s credit rating in 2011 due to what it described as “political brinksmanship”. The agency thus took the combative political atmosphere in the US government to imply that the US’ ability to pay its debt obligations might be slightly more hampered than previously thought.

2. How do different investors and organizations use credit ratings?

Many different organizations use credit ratings to aid in their investment decision-making process. Investment funds use credit ratings as a method to determine the quality of fixed income assets that they may potentially invest in. Some funds (for example pension funds) may even stipulate a minimum credit rating for the instruments to be invested in, requiring them to be at or above a certain rating in order to be eligible for investment.

Financial intermediaries including banks use credit ratings to help determine the initial pricing for individual bond issues that they are working to facilitate as well as determine interest rates and other features of the bond issue. It also allows them to determine costs of debt to use to calculate the cost of capital used to value the entity or its assets.

Similarly, other businesses and financial institutions may use the credit ratings of an entity or those of its bonds to determine how creditworthy they may be and assess the counterparty risk associated with the issuer. This may aid in the decision to lend money to the entity by the institution in question. Finally, the issuer itself can use its own credit ratings to receive an objective view of its own financial health as well as the interest rates that may be charged for future bond issues.

3. Why is a good credit rating so important?

Due to the wide and varied usage of credit ratings in the financial markets, it becomes apparent why it is important for entities to try their best to maintain a high credit rating. A higher credit rating is always better. It signals a higher quality bond, translating to increased demand for it in the market and increasing its price. An entity will thus find it easier to auction off its debt and will raise more capital in its auctions. The usage of credit ratings by banks to help in determining the interest rates they pay means that higher rated entities will pay lower borrowing costs for the entity. On the other hand, it is well established that credit downgrades lead to higher borrowing costs for entities. For example, the downgrade of General Electric by Moody’s in October 2018 led to higher yields for the company’s bonds and increased its default insurance cost. Similarly, the downgrade of California utility company PG&E by S&P led to a spike in its yield rate and a drop in its price.

Higher rated entities are considered more creditworthy and less likely to default on their credit and debt obligations, and thus other businesses are more willing to conduct business with the entity or to offer it more favourable credit terms. These factors all show the importance of a good credit rating.

4. How reliable are credit ratings? What happens if they fail?

Credit ratings tend to be fairly reliable. Credit rating agencies constantly monitor information about bonds and entities that they have rated in order to provide up-to-date opinions on how creditworthy entities or bonds may remain. In addition to ratings, many credit rating agencies publish their outlook on a rating (whether positive, stable, or negative), which informs the public what the opinion of the agency is of the future prospects of the entity or bond are. As such, credit ratings are sensitive to possible changes in the circumstances that led to the current rating and the possibility that they may change.

Nevertheless, credit ratings are not a guarantee of future performance of a bond. Indeed, many have criticized the over-reliance of rating agencies on past performance, whether in payment history or financial performance, in determining credit ratings for the future. This of course poses a problem that is inherent to all investment opportunities as there is never a full guarantee that an investment will provide a return and will not cause a loss to investors. Ratings agencies have also been criticized for being too slow to respond to new information that might affect their ratings.

Most famously, ratings agencies have been criticized for their role in the 2008 financial crisis. The rating of CDO’s and other debt instruments as investment-grade contributed to their dissemination among accredited investors. Once those bonds defaulted, their failure placed stress on the holders as well as on financial institutions that placed speculative bets that those CDO’s were safe assets. Rating agencies got the call wrong due to faulty assumptions with their rating models. It thus becomes apparent why credit ratings should be only one part of the investment evaluation process. Investors should not take credit ratings as guarantees of the safety of the assets they invest in.

Finally, credit ratings are a statement about the creditworthiness of bonds and their probability of default rather than a statement about their liquidity in the market. Thus, investors looking to sell their bonds before they have matured may find that their prices may be temporarily depressed due to current market factors such as the interest rate environment, speculation by investors, and flight to quality. An example of this is the bankruptcy of Long-Term Capital Management (LTCM), a quant hedge fund that had invested in illiquid US government bonds. While the assets themselves were safe and would be paid back, LTCM’s fall into a short-term funding crisis meant that they required short-term funding to be obtained by selling their held assets. The illiquid bonds, while safe, traded at a discount and thus were not enough to meet the credit requirements of the fund. This and other factors contributed to the fund’s surprise demise.

5. Who should consider obtaining a credit rating?

Due to their common usage and succinctly informative nature, credit ratings are very useful for all businesses. While many rating agencies focus on larger corporations and government entities, small and medium-sized enterprises should not disregard the option to obtain a credit rating to signal their financial health and creditworthiness. As mentioned above, their usage by banks and other financial intermediaries to price debt and determine borrowing costs may be of vital importance to smaller entities. Being rated allows SME’s that may otherwise find it more difficult and expensive to borrow the capital to raise the financing they need to grow and succeed. Furthermore, providing a positive signal to other companies through a positive rating shows the business to be creditworthy and capable of meeting obligations, which helps in obtaining more favourable payment terms from counterparties and business partners.

Credit rating, in short, is a very helpful method of sending a positive signal about the company and its health to the broader market. All companies should consider it regardless of size or sector.

Source from: MERatings