Question

In what ways do users rely on credit ratings? Should their reliance be reduced? Why or why not?

Answer 1

Credit rating agencies such as S&P, Moody’s and Fitch, rank debt securities based on the creditworthiness of the issuer.

Credit Rating(s):

• An assessment of the credit worthiness of a borrower in general terms or with respect to a particular debt or financial obligation
• Are forward-looking opinions about credit risk, an opinion about the ability and willingness of an issuer, such as a corporation or state or city government, to meet its financial obligations in full and on time
• Is a grade attributed to a person, an institution or a state in order to measure their ability to repay their debt at a specific point in time.

In what ways do users rely on credit ratings?

• The ratings are used to determine the market interest rate for a particular issue and also helps investors to understand the risk and return for a given issue.
• The debt issue is priced based on the stated interest rate and its market interest rate.
• Ratings do provide an evaluation of the credit worthiness of a debtor, especially a business (company) or a government by a credit rating agency. Is an expression debtor's ability to pay back the debt and the likelihood of default

Should their reliance be reduced? Why or why not?

• Yes, over reliance should be reduced.
• Reliance on credit rating leads to herds'mentality. If one investor rejects the investment opportunity based on credit rating, all other investors will reject the investment, if they all rely on the credit rating.
• Credit rating of an issue may not be the right reflection of the credit rating of the issuer.
• Credit ratings are derived based on the analysis of historical parameters. There may be a good probability that past parameters may not be right reflection of future. Hence, reliance on credit rating will force investors and lenders to ignore the future expected performance and potential of the firm. Investment decisions can go wrong.
• Lenders and investors should perform their own due diligence rather than relying too much on the credit rating.