Default risk, also referred to as ‘Credit risk’ is normally gauged by the rating assigned to the bond by an independent credit rating agency. Rating of the debt securities issued by companies, quasi-government organizations, and governments, first originated in the United States where presently there are at least five firms offering such services. In recent years, rating agencies have seen set up in several other countries. In India, too, five rating agencies, viz. CRISIL, ICRA, CARE, Fitch Ratings and Phelps and Duff have been set up.
Meaning of Debt ratings:
To understand the meaning of debt ratings, consider some descriptions offered by well known rating agencies.
Moody’s: Ratings are designed exclusively for the purpose of grading bonds according to their investment qualities.
Standard and Poor’s: A Standard and Poor’s corporate or municipal debt rating is a current assessment of the credit worthiness of an obligor with respect to specific obligation.
Australian Ratings: A corporate credit rating provides lenders with a simple system of gradation by which the relative capacities of companies to make timely repayment of interest and principal on a particular type of debt can be noted.
Looking at the above descriptions we find that a debt rating essentially reflects the probability if timely payment of interest and principal by a borrower. The higher the debt rating, the greater are the chances that the borrower will fulfill the obligation to pay the interest and principal.
Having described what a debt rating is we should also clarify what it is not.
1. A debt rating is not recommendation for purchasing, selling or holding a security. The important elements relevant for investing decision making in a debt security are (1) yield to maturity, (2) risk tolerance of the investor, and (3) credit risk of the security. Clearly, the focus of debt rating is on only one of those three elements viz., credit risk of the security, and hence it cannot be the sole basis for investment decision making.
2. A debt rating is not a general evaluation of the issuing organizations. If a debt issue of a firm X is rated higher than a debt issue of firm Y, it does not mean that firm X is better than firm Y. Remember that debt ratings being security specific is supposed to assess the credit risk of a particular debt security, nothing less and nothing more.
3. A debt rating does not create a fiduciary relationship between the rating agency and the users of a rating since there is no legal basis for such a relationship.
4. A debt rating does not imply that the rating agency performs an audit function. While the rating agency may examine various facets of a company’s working and gather information relevant to its task, it is not expected to perform an audit function or attest to the veracity of information shared by the issuer.
5. A debt rating is not a one time evaluation of credit risk, which can be regarded as valid for the entire life of the security. Changes in the dynamic world of business may imply a change in the risk characteristics of the security. Hence debt rating agencies monitor the business and financial conditions of the issuer it determine whether a modification in rating is warranted.
Functions of Debt ratings:
Debt ratings (or debt rating forms) are supposed to:
1. Provide superior information
2. Offer low cost information
3. Serve as a basis for a proper risk return tradeoff
4. Impose healthy discipline on corporate borrowers
5. Lend greater credence to financial and other representations
6. Facilitate the formulation of public policy guidelines on institutional investment
Superior Information: Debt rating by an independent, professional rating firm offers a superior and more reliable source of information on credit risks for three interrelated reasons: (1) An independent rating firm, unlike brokers and underwriters who have a vested interest in an issue, is likely to provide an unbiased opinion,(2) Due to its professional resources, a rating firm has greater ability to assess risks. (3) A rating firm has access to a lot of information which may not be publicly available.