Credit rating is a process to measure the default risk of bonds. There are credit rating agencies in every country that do this. The idea is to keep investors in safe water when it comes to investing. Credit rating agencies follow various methods to measure the ratings, including imminent market prices fallout and the malfunction in the interest rate of bonds, etc.
Credit ratings are an analysis of the risks associated with a financial entity, such as bonds and shares. A rating is assigned to an entity by renowned credit rating agencies after a thorough check of the bond's validity and future prospects. Therefore, there are various types of ratings depending on the present and future performance of the entities.
Credit rating is a bond's sign of creditworthiness. The bonds with high creditworthiness and best future market prices are offered better ratings than a bond that is doubtful or has bleak future performance. Credit ratings, therefore, help in assessing the solvency of a firm's bonds. In India, some of the best rating agencies that perform the rating include CARE, ICRA, and CRISIL, etc.
Note − Higher the creditworthiness of a bond, higher is its credibility to perform in the market in the future.
Creditworthiness − Credit rating offers an insight into a firm's creditworthiness showing how the future performance of the particular bond will be. It is a signal for investors whether to invest in a particular bond or not. Therefore, firms with higher creditworthiness get more appreciation in terms of investment than a firm that has a downgraded credit rating.
Ratings − There are different types of ratings offered by credit rating agencies. For example, in India, the best rating offered by CRISIL for a company is AAA while the worst rating is D. It means that the bonds with AAA rating are more creditworthy than bonds with other ratings, such as AA and BB. D is the lowest among the ratings that reflect the sheer inability of an entity to return the interest and capital in case of future financial or economic trouble.
Importance − Credit ratings offer the significance of a bond vis-a-vis its market performance. It is a continuous process where downgrades and up-gradation occur continually. If the rating of an entity is upgraded, it is a signal that the bond or entity has performed beyond expectation and can be bought without a doubt. Similarly, the down gradation means the bond has lost its capacity to service the debt and hence should be sold.
Note − Credit Rating should not be the only parameter to judge the basic strength of a bond. It should be only one aspect.