Role of credit ratings in capital markets

Businesses raise capital from capital markets to meet operational costs and/or for investing in expansion plans. An assessment of investment risks and credit evaluation is important for capital markets to function smoothly. It is the responsibility of the regulators to protect the interests of the investors against malpractices by any other market player.

Credit rating is a quantified assessment of the borrower’s creditworthiness and suitability for being offered debt. The rating, assigned by credit rating agencies, is based on qualitative and quantitative information. It indicates the likelihood of the borrower repaying a loan without defaulting while adhering to all the terms of the loan agreement.

A credit rating can be assigned to any type of borrower – an individual, a firm, or a sovereign government. A high credit rating is indicative of a high probability that the loan will be fully repaid, within the stipulated time. A poor credit rating indicates a poor history of loan repayment and possible trouble in the repayment of future loans.

How credit ratings benefit all the participants in the capital market

  • Credit ratings help investors make intelligent investment decisions based on their risk appetite and expected returns. The credit rating indicates to the investor the risk associated with an instrument. These ratings are periodically revised to reflect current market conditions, helping investors in the sell/hold decision. The role of credit rating agencies in the capital market is to provide an easy-to-understand rating methodology taking into consideration important factors that determine creditworthiness, making it easy for investors to make investment decisions.
  • The function of credit rating agencies is toaid issuers of financial instruments by helping them build a corporate image in the market based on facts rather than perception. A high credit rating helps issuers attract more investors.
  • Credit ratings also help stockbrokers and other financial intermediaries operating in the market. A standardized system of ratings is self-explanatory. Investors can independently assess the suitability of the various instruments available for different types of investment options like Mutual Funds, Stocks Deposits etc. These ratings also help them decide which instruments to choose for investment in the capital market.
  • Market regulators benefit from the increased transparency afforded by credit ratings. The role of rating agencies in periodically revising credit ratings (AAA, AA, BBB, C, D, etc.) is critical since this helps regulators monitor performing and non-performing companies.

Despite the many benefits that credit ratings provide, it is recommended that investors be mindful of potential pitfalls that could affect their investments.

  • Credit ratings are based on the past performance of the firm and need to be reviewed periodically to reflect current market conditions. Check the recency of the rating
  • When investing on the basis of the rating of an instrument, check the ratings of all the instruments offered by the same issuer to arrive at a holistic assessment
  • An issuer can hide important information from the rating agency. It would be advisable for investors to practice due diligence to verify the correctness of the assigned rating
  • It is essential to remember that different agencies could assign different credit ratings to the same instrument

The role of credit rating agencies in financial markets cannot be overstated. These ratings benefit all the stakeholders in the capital markets as they help make crucial information accessible to all in an easy manner – thereby helping investors make sound investment decisions into stocks, mutual funds, Deposits etc.

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