Credit Rating

Bondholders face the risk that the bond issuer default on their obligation to pay interest and
the principal amount at redemption. This so-called credit risk – the probability of an issuer defaulting on their payment obligations and the extent of the resulting loss – can be assessed by reference to the
independent credit ratings given to most bond issues.

What is Credit Risk?

Credit risk concerns the issuer’s ability to make timely payments on interest and principal. Credit risk appears in three forms.

• Default risk is related to untimely or missed payments, which is a default on the part of the issuer.
• Downgrade risk is related to the possibility of a downgrade of an issuer’s debt due to a deteriorating ability to make interest payments.
• Spread risk is the chance that the price relative to a benchmark bond will fall.

Credit analysis involves a detailed study of the issuer to anticipate changes in credit risk. Credit analysis closely looks at:

• The issuer’s existing obligations and the collateral protection available for creditors.
• Liquidity and borrowing needs.
• Cash flow needs.

Evaluating an issuer’s overall credit risk is the purpose of credit analysis.

Credit Rating Agencies

The three most prominent credit-rating agencies that provide these ratings are S&P, Moody’s, and Fitch.
Ratings. Each agency provides an opinion on the creditworthiness of an issuer. As such, the agencies have the power to determine the cost of borrowing for the firms they cover. Agencies review their ratings regularly and conduct reviews after significant financial developments. Agencies may also provide an outlook or place the issuer on a credit watch list. An issuer is reviewed with positive, neutral, or negative implications on the watch list.

Bond issues subject to credit ratings can be divided into two distinct categories: those accorded
an investment-grade rating and those categorized as non-investment-grade or speculative. The latter
is also known as ‘high-yield’ or ‘junk’ bonds. Investment-grade issues offer the most significant liquidity.

The table below provides an abridged version of the credit ratings available from the three agencies.

Although the three rating agencies use similar methods to rate issuers and individual bond issues,
essentially by assessing whether the cash flow likely to be generated by the borrower will comfortably
service, and ultimately repay its debts, the rating each gives often differs, though not usually significantly
so.

Issues such as asset-backed securities are credit-enhanced to gain a higher credit rating. The simplest method of achieving this would be through an insurance scheme that will pay out should the pool of assets be insufficient to service or repay the debt.

During the financial crisis, credit rating agencies were subject to a large amount of criticism for how they failed to correctly assess the risk of certain kinds of securities that were issued. In addition, due to the deficiencies of the method of rating credits, there is now increased oversight by regulators of the credit rating function.

Conclusion: Credit Risk Evaluation by External Agencies Help in Investment Decision Making

Debt instruments rated by Credit Rating Agencies (CRAs) include government bonds, corporate bonds, CDs, municipal bonds, preferred stock, and collateralized securities, such as mortgage-backed securities and collateralized debt obligations.

The issuers of the obligations or securities may be companies, unique purpose entities, state or local governments, nonprofit organizations, or sovereign nations. A credit rating facilitates the trading of securities on a secondary market. It affects the interest rate that a security pays out, with higher ratings leading to lower interest rates.

Credit rating agencies help investors gather information about different companies’ creditworthiness. So, investors can make an informed decision to invest in bond securities issued by a company.