Most bonds and corporate deposits are credit rated. Ever wondered what credit ratings like AAA and AA mean? We’ll tell you all about them.
A credit rating is a symbol that helps determine (to a reasonable extent) the amount of risk involved in investing in a particular debt instrument. The risks relate to timely payment of interest and principal.
Most rating agencies rate debt instruments on three scales – long-term, short-term and Fixed Deposit scales. As the names suggest, a short-term scale is for short-term debt instruments with a tenure that ranges from a few days to a year, while anything more than a year is long-term. There are many credit rating agencies that assess the instruments and assign the ratings. These include CRISIL, ICRA, CARE and FITCH. Each of them has their rating scales.
Additional Reading: Protect Your Credit Rating At All Times
Let us explore one of them to understand how credit ratings work.
Let us take the example of CRISIL, a rating agency. CRISIL’s long-term scale rating ranges from D to AAA where D is defined as ‘default’ and AAA is termed as ‘highest safety’. ‘Highest safety’ means that the issuer has a very strong capacity to repay the interest and the principal on time. Short-term instrument ratings range from P5 to P1. Fixed deposits are rated from FD to FAAA. Plus and minus symbols are used to show distinction within a category. This means that the ones with the plus signs are slightly better than ones with minus.
Even though the rating agencies have their own rating scale, most of the times, they are very similar. Let’s take the case of CRISIL and ICRA. While CRISIL has an AAA, it is LAAA in ICRA. CRISIL gives P1 while ICRA assigns an A1.
Along with the ratings, agencies also give a rating outlook for the instrument. Rating outlook tells investors the direction in which the ratings will move in the next two to three years. This is only for long-term instruments.
Caveats
- Many believe that a high credit rating translates to a ‘buy’ recommendation, which is false. A credit rating merely tells you the probability of default. So, do not buy any investment based on the credit rating alone. You need to research about the company and its prospects before choosing to invest.
- It should be noted that a high credit rating means the probability of the debt issuer defaulting is low, but not nil.
- Ratings are given for a particular debt issue and not for the company as a whole or all the instruments issued by the company. So, don’t look at the credit rating of a company. You need to look at the credit rating of the particular instrument.
- Even though rating agencies say they are unbiased, it is prudent to note that companies pay to get their instruments rated.
Rating agencies monitor ratings and the ratings can be changed over the tenure of the investment. These changes are based on several factors like change in business environment, the financial position of the company etc. Just like a straight ‘A’ student may not turn out to be the best employee, a debt instrument with an ‘AAA’ rating needn’t be the best investment.
Credit ratings should just be used as one of the criteria for analysing debt investments. If you are not sure about the investment, it is better to go for a debt Mutual Fund. Here, the fund manager will assess the company, the investment and the ratings before investing in them.