A rating agency is an organization that specializes in assessing the financial strength of a company or government entity that uses the capital markets for financing. The rating provides a measure of these companies solvency, i.e., their ability to fulfill their financial obligations. Furthermore, the rating agencies use a unique letter-based code that shows the risk (high or low) of debt and the financial stability of the issuer.
The debt issuers can comprise non-banking finance companies, banks, public and private sector units, sovereign nations, state governments, etc.
- Types of Rating
- Functions of the Credit Rating Agency
- Benefits of Credit Rating
- To the Investor
- To the Company
- Demerits of Credit Rating
- Major Rating Agencies
Types of Rating
There are different ratings that the rating agencies provide. These are:
A bond/debenture rating is the rating that the rating agency provides on the debentures and bonds that the government or corporate issues.
The equity shares are the main source of finance for a firm. The company issues these shares to the general public. The rating agency rates the equity shares. It is called equity rating.
Preference Share Rating
The preference shares are the shares having the fixed dividend and get the priority at the time of payments over the equity shares. The ratings of the preference shares issued by the company are called preference share ratings.
Commercial Paper Rating
Commercial papers are short-term borrowing instruments. The manufacturing companies, finance companies, banks, and other financial institutions issue these instruments. The rating of these instruments is called commercial ratings.
Fixed Deposits Rating
Fixed deposits are the instruments that the banks provide to the investor. These instruments have a higher rate of interest than the ordinary savings account. The rating of these instruments is called fixed deposits rating.
The rating agencies rate a borrower to access his creditworthiness in general or with respect to a particular debt or certain financial obligation. Rating of borrowers is referred to as borrower rating.
The rating agency rates an individual based on his ability to fulfill his financial obligations. This rating of individuals is known as individual credit rating.
Sovereign ratings are very important in today’s scenario. Countries around the globe are tapping international markets. The rating agencies access sovereign entities like the governments by considering the risks (political risks, regulatory risks) and other factors in determining the possibility of default.
Functions of the Credit Rating Agency
Credit rating agency provides superior information on credit risk. Being an independent rating agency, it will offer an unbiased opinion. Competitive and trained staff improves the ability to assess risk. Also, these agencies have access to vast information which is sometimes not available publically.
The Basis for Risk and Return
The security enjoys higher confidence from the investors if it has been rated by the rating agency. The investor has an idea about the risk he takes if he makes an investment in that security.
Less costly Information
The rating agency provides the information in a simple and easy-to-understand manner. Investors find it expensive and impossible to do such evaluations on their own. Therefore, the information that rating agencies provide is highly acceptable to them.
Discipline on Corporate Borrowers
The credit rating affects the image and the visibility of the corporate. A high credit rating for an investment of the corporate has a positive impact on its image and visibility. So, It induces discipline in corporate borrowers.
Financial and Other Representations Gain Greater Credibility
The credit rating agency’s own reputation is at stake when it rates security. Therefore, they seek proper financial and other information. To continuously provide the rating agency the required information, the financial and other representations of the issue gain greater credibility.
Benefits of Credit Rating
To the Investor
Helps in Investment Decisions
The credit rating agency gives the investor an idea about the credibility of the issuer. Also, the risk factor that a particular instrument carries. Knowing this, the investor can decide whether or not to invest in that company. A high rating increases the willingness to invest and visa-verse.
Rating Reviews Benefit
The rating agencies review the rating given to particular security regularly. So, the investor can decide to keep or sell the security. For example, if the rating of a security falls or downgraded, the investor can sell that security.
Promise of Security
A high credit rating of security gives the assurance to the investor that the security is safe to invest and the risk of bankruptcy is also minimum. The companies getting higher ratings on their securities try to maintain the financial discipline, reducing the chances of bankruptcy. Therefore, the investor will be safe.
Easy Understanding of the Investment Proposal
The rating symbols that the agency gives to the instruments are easy to understand. Therefore, the investor will be able to understand the proposal of the issuer.
Saves Time and Effort
To make an investment decision, the investor can rely on the ratings these professional rating agencies provide. As a result, the investor saves time and effort.
To the Company
Helps to Improve Corporate Image
Credit rating helps companies to improve their corporate image. The high credit rating increases the confidence and trust of the investors. Therefore, the companies having high credit ratings enjoy a good corporate image in the market.
Lower Cost of Borrowings
A company having a high rating instrument reduces the cost of borrowings. The company can quote lesser interest on deposits or bonds, or debentures. Investors having a low-risk preference will come forward to invest in safe securities, even if these securities yield a lower rate of return.
A Wider Audience for Borrowings
A company with a higher rating enjoys a wider audience for borrowings. The financial institutions, banks, and investment companies are within the approach of the company. This is because of the easy understandability of the credit rating, the company can raise funds not only from banks and financial institutions but also from the public.
Perform as a Marketing Tool
The high credit rating improves the image of the company. Therefore, the company can use it as a marketing tool to create an enhanced image in dealings with the customers. The customers will feel confident in the products of the companies that are carrying high ratings on their instruments.
Motivates for Growth and Expansion
Good ratings motivate the company for growth. The promoters feel confident in their efforts and feel encouraged to expand their operations or enter new projects. A better image helps the company to get finance easily. So, the company can easily take a step toward growth and expansion.
Demerits of Credit Rating
Probability of Biases and Misrepresentations
The information that the rating agencies collect may be subjected to the personal bias of the team. However, the rating agencies work very hard to provide an unbiased opinion. If they do not do so, the companies and investors will not trust them.
Non-disclosure of Certain Information
The company that the rating agencies are assessing sometimes does not disclose certain facts to the investigating team of the agency. Consequently, affecting the quality of the ratings.
The rating agencies base the ratings on the past and present data of the company. Therefore, the prediction of the future financial condition of a company is very difficult. The economic, political, social, technological, legal, and other environments changes with the change in time. These affect the working of the company that is being rated. Therefore, the rating cannot be considered as a guarantee for the financial soundness of the company.
Issues with New Companies
The new companies face the problem of raising funds from the market. Because they are not in the position to prove their financial soundness. Therefore, they receive lower credit ratings. This makes the raising of funds from the market difficult for them.
Difference in Rating
There are cases where the different rating agencies provide different ratings to the same instrument. These differences can arise because of various reasons. Such as, companies have different methodologies and codes to access securities. These differences create confusion in the mind of investors.
The credit rating agencies periodically review the ratings given to the instruments. If the company’s performance is not up to the mark, then the rating agencies will lower the grade of that instrument. It affects the image of the company.
Major Rating Agencies
There are three major rating agencies that control approx 95 % of the rating business in the world. The top firm includes Standard and Poor’s Financial Services LLC, Moody’s Investor Service, and Fitch Ratings.
Standard and Poor’s was founded in the year 1860, headquarter is situated in New York, USA. Moody’s was founded in the year 1909, headquarter is situated in New York, USA. Fitch was founded in 1914, headquarter is situated in New York, USA.
The S&P and Moody’ together control 80% of the international market. At the same time, the Fitch controls 15% of the market internationally. The U.S. Securities and Exchange Commission (SEC) recognizes these three agencies as the Nationally Recognized Statistical Rating Organizations (NRSRO).