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Credit rating agencies are responsible for the assessment of the creditworthiness of an individual or an organisation. The agencies assign ratings by evaluating financial statements, types of debt, lending and borrowing history, and repayment ability, to rate state governments, companies, NPOs, securities and local government bodies.
A rating agency evaluates the credit risks associated with a financial instrument or an entity that helps in measuring the solvency of the entity. It plays a significant role in boosting the confidence of the stakeholders in the financial markets.
The ratings assigned by these agencies help investors in deciding their investments and gives them a better understanding of the risks associated with the company or instrument that they could face.
Credit ratings are an essential factor to consider while investing be it in fixed deposits (FD), company deposits, NCDs or other investments.
Importance of credit rating
For a company, a rating downgrade indicates that the company’s ability to repay the respective financial instrument has declined, which, in turn, hampers its ability to borrow further.
While selecting a company deposit to invest in, one should go for a company that has the highest credit rating. A rating of AAA, or at least AA, is the safest deposit to look for. If the credit rating of the deposit you have invested in falls, it is advisable to withdraw from it even if one has to pay the penalty for premature withdrawal.
In case of investing in a debt mutual fund scheme, if a security in the fund witnesses a downgrade in its rating, the direct knock-on effect will be that the net asset value of the scheme will be negatively impacted. However, the magnitude of the impact will depend on the percentage of that security in one’s portfolio. The higher the exposure to a security that has a rating downgrade, the higher is the negative impact on the scheme’s net asset value.
Nevertheless, one should not make investment decisions solely based on the credit rating of a company or an instrument. Ratings can very well change during the investment period. Hence, credit ratings should not be the only parameter one considers while making investment decisions.
Rating Agencies and their Ratings
There are three global credit rating agencies- S&P Global, Moody’s and Fitch. On the one hand, AAA, AA, A and BBB are investment-grade categories, BB, B, CCC, CC, C and D are speculative-grade rankings on the other. Rating agencies attach different modifiers to these to further differentiate and position.
AAA and AA are high credit quality ratings while A and BBB fall under average quality ratings. However, the exact ratings depend on the rating agency as each rating agency has a different defined symbol for giving a rating. The ratings of BBB and above are referred to as Investment grade, which signifies a relatively lower risk of credit default, making them desirable investment options.
Government bonds (also known as Treasuries) do not have any credit quality ratings, yet they are considered to be one of the safest instruments to invest.
Ratings that are below the designations mentioned above are considered to be of low credit quality.
Causes of a downgrade
When the business performance of an issuer deteriorates, and it is unable to make interest payments on borrowing on time, the credit rating company pulls its rating down. This is identified as a rating downgrade.
One of the primary reasons that companies face a rating downgrade is their deteriorating finances. Banks with huge NPAs, companies with high debt to equity ratio showing its inability to pay its debt, and firms with poor interest coverage ratio are some of the factors that can lead to downgrades.
Investors must know that an agency downgrade of the company’s bonds from say BBB to BB converts its debt from investment grade to junk status.
Junk status shows that a company may struggle to meet its debt obligation. This further increases the stress of the company by making it more difficult to source financing options. This is because the cost of capital increases for such companies as investors seek higher returns for the increased risk they take.
How do downgrades impact investors?
A Company’s stock price immediately falls following a downgrade, which impacts equity investments of an investor in the short run. Even the investments in debt mutual funds can be affected by the change in rating.
Ratings downgrade of a bond results in an increase in yield payable on the bond, which leads to a fall in price. However, bond prices do not move only based on the changes in ratings. Changes in global interest rates, monetary policy, liquidity conditions and economic factors are some of the factors that also affect interest rates.
How to be Proactive in knowing the financial performance of the issuer?
A negative rating stance indicates ratings are expected to be downgraded further. One should also conduct a thorough research by identifying non-performing asset levels or bad loans of the company.
One can also look for the debt to equity ratio and interest coverage ratio of the companies. While the debt to equity ratio is a measure to know the level up to which the company is financing its operations through debt, the interest coverage ratio depicts how easily a company can pay its interest expenses on outstanding debt.
Higher the Interest coverage ratio and lower the debt to equity ratio, better is the borrower’s ability to service its debt obligations.
Steps that can be taken while making an investment
A single downgrade is not a reason to worry, but multiple ones are. One should take note of the recent credit ratings and outlook of the bank or company to get a better picture of its financial situation.
If the rating of the company has been downgraded, one should look at the explanation provided by the company for the downgrade. If the reasons provided seem inadequate, investments from that company should be pulled out once prices recover after the downgrade.
Debt mutual fund investors must keep a watch on the ratings of the debt investments that are being made by the fund house. If the fund invests a lot in lower-rated companies, one must look for an exit from the fund house.
