Credit Ratings

 (Republished with permission from CRISIL - © 1997 CRISIL Limited - All Rights Reserved)

What is a credit rating?

A credit rating is an opinion on the relative degree of risk associated with timely payment of interest and principal on a debt instrument. A simple alphanumeric symbol is normally used to convey a credit rating.

How does a credit rating agency differ from a credit bureau?

A credit rating agency provides an opinion relating to future debt repayments by borrowers. A credit bureau provides information on past debt repayments by borrowers. Trade creditors are generally the main users of credit bureau information, while financial investors typically use credit ratings. Information relating to a company's track record in debt servicing, supplied by credit bureaus, is one of the inputs that is used by a credit rating agency while assigning a rating.

Is a credit rating a recommendation to invest in a debt instrument?

A credit rating is not a recommendation to buy, hold or sell a debt instrument. A rating is one of the inputs that is used by investors to make an investment decision. Investors also look at the returns being offered on the debt instrument. Normally investors expect higher returns for lower rated instruments to compensate for the increased risk profile. Rating agencies do not comment on the return being offered on a debt instrument. Also, investors use several other factors like level of portfolio diversification and liquidity levels of the instrument etc. in making investment decisions.

What is the difference between credit ratings and equity research?

Credit ratings are assigned to debt instruments while equity research relates to equity shares. The risk and return characteristics of debt and equity instruments are fundamentally different, even though issuers service both out of business earnings. Debt instruments offer a guaranteed but fixed return while equity instruments offer a potentially unlimited though non-guaranteed return. Therefore, while equity research is focused on growth possibilities, for that is what drives equity valuations, a credit rating is focused on the risk of non-payment, the primary variable in debt instruments. This difference in orientation distinguishes credit ratings from equity research.

How does a credit rating differ from an audit?

A credit rating agency relies on a variety of information sources including published annual reports, meetings with the issuer’s management, industry data and discussions with bankers. Though rating agencies carry out due diligence on this information, it does not always amount to the kind of verification that is carried out by an auditor. A credit rating depends significantly on the quality of information on which it is based. Also, the credit rating process may not be able to detect fraud or misrepresentation of information – something that an audit is designed to detect.

Source: CRISIL Limited

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