Bond purchases, like all investments, come with a certain amount of implied risk. The primary hazards of bond investing are the potential for non-payment and capital loss, caused by a decline in the instruments’ market value. Credit rating is the shortest profound and comprehensible profitability assessment of a given entity from viewpoint of its creditors. It gives an objective external opinion for the ability of a given debtor to serve his financial debts in a timely manner. Credit ratings are formed and disseminated based on established methodologies, models and criteria that apply to entities and securities that Credit Rating Agencies (CRAs) rate, including corporate finance issuers, financial institutions, insurance companies, public finance and sovereign entities as well as structured finance transactions.
The credit risk of issuers within a given jurisdiction is derived directly from the risk level of the State.The Government’s credit rating directly impacts other local bond issuers such as banks, public companies and state-owned enterprises. The sovereign rating usually serves as a ceiling for domestic enterprises’ own ratings, functioning as a reference point for pricing their bonds.
The reasons for the connection are as follows: A sovereign may impose currency controls on residents, effectively making the State a monopoly in the foreign currency revenues in the relevant territory. The country’s credit rating is indicative of macroeconomic conditions affecting a sovereign economy. This may influence foreign investors’ decision whether to operate within said economy. In some cases, the State guarantees corporate debt (especially that of government companies). While individual investors need to focus on their specific investment decisions, the time-consuming task of comparing sovereign risks and its impact all over the world is taken on by CRAs.
Credit Rating Agencies are creating value beyond data and information. At the heart of what makes them different is their people. They are powered by human insight and a collaborative culture that drives them forward – providing their clients and partners with the insight that has an impact on economies, businesses and livelihoods all over the world. Credit rating agencies play an important role in providing one source of information that aids market efficiency by reducing information costs, increasing the pool of potential borrowers, and reducing the imbalance of information that often exists between buyers and sellers of bonds. Their ratings are dedicated to improve the risk/reward decision-making capabilities of investors globally, while allowing issuers to access capital markets at premiums commensurate with their objectively assessed credit risk.
Credit risk is not only dependent on the organization of an issuer, but also dependent on an instrument’s individual attributes and many other factors. Government bonds denominated in local currency have a relatively low default risk, as sovereigns generally have the ability to print the money needed to repay creditors. For these securities, investors are exposed to a potential drop in the bonds’ value due to increased government debt issuances and inflation. These factors may erode a bonds’ real value. For bonds denominated in foreign currency there is a tangible risk of non-payment, as sovereigns are generally unable to print money to meet obligations.
Few investors have the time, resources or ability to frequently monitor issuer conduct and financial performance to derive the risk level associated with an investment.
The credit rating agencies perform these functions on behalf of investors. Credit Rating Agencies are supposed to use methodologies that are rigorous, systematic, continuous, dynamic and subject to constant validation, and should be completely independent and unbiased, politically and geographically. CRAs are obliged to work on the basis of strict internal controls as well as a robust and comprehensive system of governance. Their work includes monitoring issuers and their issues, reviewing issuer activities; publishing all relevant data to assess investment risk and assessing risk level according to a fixed proprietary scale.
Credit rating agencies take both an issuer’s ability to repay and the degree of commitment to debt repayment into account. With the expansion of the financial markets lending has become more complex and sophisticated. Credit rating is now vital to evaluating potential financial transactions and assisting in bond pricing. Credit rating reduces the dimension of uncertainty faced by potential investors, encouraging investment, and therefore declines in funding costs. In summary, credit rating is of vast importance, not only to the public sector, but to the economy as a whole.