Author Topic: What is credit rating and how important is it.  (Read 2504 times)

Maliha Islam

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What is credit rating and how important is it.
« on: February 18, 2019, 01:30:31 PM »
What is credit rating and how important is it while making an investment decision?

This week, rating agencies, ICRA and India Ratings and Research, downgraded IL&FS's non-convertible debentures (NCDs) and long-term loans. The downgrade has had a ripple effect - share prices of its group companies dropped, concerns are now growing about the future of the company, and it has come to light that many debt mutual fund schemes have exposure to the company.

This is not the first time a downgrade in credit ratings of a company has had widespread ramifications. In 2015, Amtek Auto was downgraded, a fall out of which was that JP Morgan Mutual Fund faced rough weather in the following months. And in 2017, credit rating agencies downgraded bonds of IDBI Bank and Reliance Communications, which led to the share prices of both companies tanking.

Credit ratings are an important parameter to consider while investing be it in fixed deposits (FDs), company deposits, NCDs or other investments. For equity, initial public offerings of shares are also rated.

What are the credit ratings?
Credit rating is an analysis of the credit risks associated with a financial instrument or a financial entity. A rating is assigned to an instrument by a credit rating agency after a comprehensive analysis of business risks, financial risks, management quality and ability to service debt.

It is a detailed report based on the financial history of borrowing or lending and creditworthiness. It helps in assessing the solvency of the entity. These ratings are assigned by credit rating agencies such as CARE Ratings, CRISIL, ICRA, India Ratings, and Research etc.

How important is credit rating?

A rating downgrade essentially means that the company's ability to service/repay that particular financial instrument has declined which in turn hampers the company's ability to borrow further. Lenders may hesitate lending to such companies and may not even roll-over (refinance) existing debt.

For instance, when selecting a company deposit to invest in, you should go for one with a high credit rating. If investing in company deposits, it is advisable to go for a deposit with a rating of AAA or at least AA, nothing lower. And if the credit rating of your deposit falls after you have invested in it, it is advisable to get out even if it means you have to pay a penalty for premature withdrawal.

If the debt mutual fund scheme you have invested in holds a security whose rating has been downgraded, the immediate fallout will be that the NAV of the scheme will be negatively impacted. However, the quantum of the impact will depend on the percentage of of that particular security in the scheme's portfolio. Obviously, the higher the exposure to the downgraded security, the stronger the negative impact on the scheme's NAV.

However, one should not base one's investment decision solely on the credit rating of an instrument or company. This is because ratings are not constant and, there is every possibility that it can change during your investment period. Credit rating should be used as one of the parameters in your decision.

Credit rating scale
There are a few important credit rating agencies companies approach to get rated. These include CRISIL, CARE Ratings, ICRA, India Ratings and Research, and BrickWorks Ratings. Here is a look at the ratings symbols used by the credit rating agencies for long-term debt instruments.