Rating Agency

They can check the creditworthiness of issuers of debt obligations, debt instruments, and, in some situations, underlying debt servicers, but not individual customers.

A credit rating from one or more credit rating organizations is attached to most debt instruments issued in the public international securities markets (CRAs).

Rating Agency

A rating agency can check the creditworthiness of issuers of debt obligations, debt instruments, and, in some situations, underlying debt servicers, but not individual customers.

The goal of credit rating agencies (CRAs) is to offer an objective and analytical assessment of the risk of payment defaults by examining a variety of criteria that assist investors in determining whether or not to invest in certain securities.

Investors in capital markets are risk-averse, and some are prohibited from investing in low-grade assets by their constitutional papers. Generally, the bigger the investment risk, the larger the investor's desired return (interest/coupon).

Credit ratings are also used by financial intermediaries, such as investment banks, to ease the structuring and issuing of securities in the capital markets. 

They utilize credit ratings to estimate the possible price of individual debt issues they shape and benchmark other debt issues' relative credit risk.

The credit rating industry is highly consolidated, with the "Big Three" credit rating companies owning over 95% of the market share. Moody's Investors Service and Standard & Poor's (S&P) control 80% of the worldwide market, with Fitch Ratings controlling 15%.

Moody's Corporation 

A credit rating agency gives credit ratings, which assess a debtor's capacity to repay the debt by making timely principal and interest payments and the risk of default. 

A rating agency can evaluate the creditworthiness of debt obligations, debt instruments, and, in some situations, underlying debt servicers, but not individual customers.

In contrast to long-term ratings, Moody's short-term ratings are based on an issuer's ability to repay all short-term commitments rather than on specific short-term borrowing programs. 

A short-term rating is worldwide in scope once it has been given to an issuer; it applies to all of the issuer's senior, unsecured liabilities having an initial maturity of less than one year, regardless of the currency or market in which they were issued. 

If another business backs up an issuer's rating via a letter of credit or guarantee, there is an exception to the worldwide character of these ratings.

Short-term Rating Definition

  1. P-1: Prime-1-rated issuers (or supporting institutions) have a superior capacity to fulfill short-term loan commitments.
  2. P-2: Prime-2-rated issuers (or supporting institutions) have a high capacity to fulfill short-term loan commitments.
  3. P-3: Prime-3 issuers (or supporting institutions) have a reasonable capacity to repay short-term debt.
  4. N-P: Not Prime issuers (or supporting institutions) do not fit into Prime rating categories.

buildings

Long-term Rating Definition 

Long-term obligation ratings from Moody's are assessments of the relative credit risk of fixed-income securities having maturities of one year or longer. 

They deal with the possibility of a financial commitment not being met as agreed. Therefore, the possibility of default, as well as any financial loss experienced in the case of default, is reflected in these ratings.

Long Term

S&P Global ratings

S&P Global Ratings (formerly Standard & Poor's and abbreviated as S&P) is a section of S&P Global that produces financial research and analysis on stocks, bonds, and commodities. 

The big three credit-rating organizations include Moody's Investors Service and Fitch Ratings. The company is headquartered at 55 Water Street in Lower Manhattan, New York City.

Global Rating

Long-term Rating Definition 

The scale ranges from AAA to D, with (+) and (-) ratings available at each level between AA and CCC (for example, BBB+, BBB, and BBB-). 

S&P may also provide advice (known as a credit watch) on whether it is likely to be upgraded (positive), downgraded (negative), or remain unchanged (neutral).

  1. Investment Grade: AAA, AA, A, BBB (from the highest grade to a good quality that is susceptible to changing economic situations).
  2. Non-Investment Grade (Junk): BB, B, CCC, CC, C (speculative; ranging from the most basic to the most advanced levels of speculation); D (in payment default).

Short-term Rating Definition 

From A-1 to D, the scale is used. A plus sign (+) next to an A-1 rating indicates the issuer's commitment to meet its obligations is particularly strong.

1. A-1, A-2, A-3 (from the highest grade to a good quality susceptible to changing economic situations).

2. B, B-1, B-2, B-3 (speculative; ranging from the most speculative to the most speculative). 

Short Term

3. C (Currently, the company is sensitive to nonpayment and is reliant on favorable corporate, financial, and economic conditions.).

4. D is for (in payment default or bankruptcy petition filed).

Fitch Ratings 

Fitch Ratings is a credit rating company based in New York and London. Investors use this company's ratings to identify assets unlikely to default and provide a favorable return. 

It is the third-largest NRSRO rating agency, with a smaller market share than S&P and Moody's. At the same time, it has grown through acquisitions and frequently serves as a "tie-breaker" when the other two agencies have ratings that are similar in scale but not equal.

Fitch Ratings

Long-term Rating Definition 

Investment class

  • AAA: A corporation of exceptional quality (established with stable cash flows) 
  • AA: A high-quality company with a risk somewhat higher than AAA. 
  • A: A company with a low risk of default is more susceptible to economic or business circumstances. 
  • BBB: The company's default expectations are low. On the other hand, economic or business variables can have a negative impact.

Non-investment class

  • BB: Vulnerability to default risk is increased, as is susceptibility to unfavorable market or economic developments. 
  • B: The financial situation is deteriorating, and the market is highly speculative. 
  • CCC: Substantial credit risk, low margin of safety, and high possibility of default... 
  • CC: The likelihood of default is extremely high.
  • C: Start with the default or a process similar to the default. 
  • RD: The issuer's payment default has been documented. D: The company has defaulted

RD

Short-term Rating Definition 

Fitch's short-term ratings imply the likelihood of default during the next 12 months. 

  • F1: highest quality rating, showing the obligor's excellent ability to pay its financial obligations. 
  • F2: good quality grade with obligor's ability to satisfy its financial obligations. 
  • F3: a fair quality grade, indicating that the obligor has the financial capacity to satisfy its obligations but that a near-term unfavorable situation may jeopardize the obligor's obligations.
  • B: speculative, with the obligor having limited capacity to satisfy its obligations and being vulnerable to short-term bad financial and economic situations 
  • C: The risk of default is significant, and the obligor's financial commitment is contingent on continued, favorable business and economic conditions. 
  • D: obligor has defaulted because they have failed to meet their financial obligations.

Advantages

Some of the advantages are:

1. Freedom of Investment Decisions

It is quite difficult for ordinary individuals to make investing decisions. Instead, they seek guidance from stock brokers, merchant bankers, and portfolio managers before making financial decisions. 

Credit rating services simplify the work by assigning rating symbols to a specific investment. Therefore, credit rating is one of the most important aspects to consider while doing the entire valuation. 

Advantages

2. Lower the Cost of Public Issue

When acquiring cash through a public offering, a company with highly rated instruments must put forth the least amount of work. In addition, a strong credit rating boosts the company's visibility. 

In the eyes of consumers, shareholders, investors, and creditors, companies with highly rated instruments have superior goodwill and corporate image. 

This is especially to be applied to companies that respect ESG investing. 

3. Lowers Cost of Borrowing

When raising cash from the market, a corporation with highly rated debt instruments needs to put forth the least effort. A high rating indicates low risk. 

The corporation will be able to give a low-interest rate due to the instrument's high rating. Because there is little danger involved, investors will accept a low-interest rate. 

A high credit rating allows the organization to borrow from a larger range of sources. For example, it can readily borrow money from financial institutions, banks, investment firms, and the general public.

Disadvantages

A few of the disadvantages are:

1. Possibility of Bias

The credit rating agency may not receive all material or important information from the rated company. Therefore, any action made without such critical information may result in investors losing. 

However, since 2008, a lot of changes to the system, and the norms have gotten stricter.

This can address such a disadvantage and reduce the risk of false crediting.

Its rating is based on information gathered from the company. The rating team's personal bias may skew the information gathered by the rating agency.

Disadvantages

2. Problems for New Company

Rating organizations use the information provided by the company to assign ratings. On the other hand, a new company may not be able to present enough evidence to demonstrate its financial stability. As a result, it may receive a lower credit rating. A poor credit rating might make obtaining loans from the market difficult.

However, credit rating for new companies does not have a major impact on the investment analysis rather than analyzing the performance in the future (financial statements analysis). 

3. Ratings are not a Certificate of Soundness

The rating agencies' grades are their judgment of the company's ability to satisfy its interest obligations. 

Rating symbols do not indicate product quality, management, or personnel, among other things. To put it another way, a rating does not imply that a corporation is completely sound.

A variety of political, economic, social, and environmental factors have a direct impact on the company's operations. Therefore, any changes made after the rating may defeat the rating's objective.

Rating Methodology

Some of the methodologies are:

1. Business Risk Analysis: 

A business risk analysis aims to examine the industry risk, the company's market position, operational efficiency, and legal situation. 

This involves an examination of industry risk, the company's market position, operational efficiency, and legal situation.

Warehouse

2. Industry Risk: 

Rating agencies assess industry risk by considering a variety of variables, such as the strength of the industry's prospects, the type, and foundation of competition, demand and supply, industry structure, business cycle pattern, and so on. 

Price, product quality, distribution capacity, and other factors pit industries against one another. Industries with predictable demand growth and capital expenditure flexibility are in a better position and, as a result, have a higher credit rating.

3. Financial Analysis: 

Through ratio analysis, cash flow analysis, and a study of the existing capital structure, financial analysis tries to determine the issuing company's financial strength. 

This includes an examination of four critical factors: a. Accounting quality, b. Profitability/earnings potential c. Analysis of Cash Flows d. Economic adaptability 

Financial analysts use quantitative methods such as ratio analysis to determine the issuer company's financial strength. In addition, a company's history and current performance are assessed to forecast its future performance. The following are the areas that were considered.

Existing The debt/equity ratio, alternative sources of financing used to generate cash, ability to raise funds, asset deployment potential, and other aspects of a company's capital structure are all examined.

Did you know?

Question Mark

  • Credit rating agencies (CRAs), which grade debt instruments/securities based on the debtor's ability to repay lenders, played a key part in the subprime mortgage crisis in the United States in 2007–2008, which led to the Great Recession of 2008–2009. 
  • Without ratings from the "Big Three" rating agencies-Investors Moody's Service, Standard & Poor's, and Fitch Ratings-the new, complicated "structured finance" products used to finance subprime mortgages could not have been offered. 
  • Many money markets and pension funds, for example, were where required by law to hold only the safest securities-those rated "triple-A" by rating organizations.

So these agencies were one of the main reasons that led to the  Recession in 2008.

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Researched and authored by Charbel Yammine | LinkedIn

Reviewed and edited by Aditya Salunke I LinkedIn

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