A credit rating, in simple terms, indicates the probability of a borrower repaying the debt or defaulting on debt payments. Debt payments include both the interest and the principal. A poor rating indicates a high probability of default on debt payments.

A credit rating is assigned to either a debt security or a borrower by a credit rating agency. Globally there are three major rating agencies: Standards & Poor’s, Fitch and Moody’s. In India, there are four ratings agencies: CRISIL, ICRA, Fitch and CARE. Except for CARE, all three rating agencies in India are subsidiaries of the major global rating agencies. Every rating agency has its own scale of credit ratings to indicate the probability of default.

Government securities (or GILTS) have a sovereign rating (SOV), indicating absolutely no risk of default for the citizens of that country.

Need for Credit Ratings

Although it is not mandatory for a debt security to have a credit rating, most debt securities do get a credit rating from one of the four agencies as this provides a standard that investors can use to compare debt from different borrowers more easily, without spending too much time on analysing the credit-worthiness of the borrower. A debt security that has a credit rating is more easily bought or sold than a debt security that does not have a credit rating.

Credit ratings also determine the rate at which the borrower can borrow from the market. A debt security with AAA can borrow at the lowest rate in the markets, which will be slightly above the Government securities rate of the same maturity period. As one moves down the rating scale, the borrower needs to pay a higher interest rate to compensate for the higher risk.

Credit Ratings for Debt Mutual Fund Investors

Debt mutual fund investors must also understand the significance of the credit ratings before they invest their money into a debt fund. A debt mutual fund invests in many debt securities with different credit ratings. Investors should make sure they are comfortable with the credit ratings of debt securities that the fund invests in, otherwise they would be taking unwarranted risk which may later lead to losses.

Long and short term debt securities have different ratings. Long-term debt refers to the debt wherein the maturity of the security is greater than one year. Short-term debt refers to debt whose date of maturity is less than one year. Different ratings are needed for long and short term debt because long-term debt tends to be more sensitive to changes in interest rate than short term debt.

Long-Term Debt Ratings

The long-term credit rating scale ranges from AAA to D. AAA indicates a low probability of default and D indicates that the borrower is in default, or will most likely default.  An additional ‘+’ or ’–‘ sign is affixed to the ratings (except for AAA and D) to indicate higher or lower quality among the debts of the same rating. For instance, a debt security rated AA+ has better quality than AA. A debt security rating of AA- is of lower quality than a rating of AA.

 The long-term rating scale is pretty similar across all four rating agencies.  AAA is the best credit rating possible for a non-government debt security. This rating indicates that the borrower will repay the principal and the interest on time and has adequate reserves to fulfill debt payments. Ratings from AAA to BBB- are considered investment-grade ratings. Debt securities rated from AAA to BBB- are mostly purchased by mutual funds and institutional investors, as they are safer than speculative debt securities.

Any rating below BBB- (i.e., BB+ and below) is considered speculative grade. These debt securities are for people who can take high risk as the risk of default is considerably higher in comparison to investment-grade debt securities. The returns are also considerably higher than investment-grade debt securities. Such speculative securities are more commonly known as high-yield securities. Globally, there are special mutual funds called high-yield funds that invest into these speculative-grade securities. As of now, there are no high-yield mutual funds in India.

Any security with a ‘D’ credit rating will default or has already defaulted. These securities are for investors who are comfortable with very high risk. Most issuers of D-rated debt instruments are sick companies  in the process of financial reconstruction. If the issuer is able to recover financially, then the D-rated debt security holder gets returns of high magnitudes.

The long-term credit ratings for all four rating agencies are shown in Table 1

Short-Term Debt Ratings

While long-term debt ratings are similar across the four ratings agencies, short-term debt ratings vary far more.

The length of the scale is different for different ratings agencies. The rating scale ranges from 1 (highest quality) to 5 (lowest quality). The rating agency can use ‘+’ or ‘-‘ to indicate better or lower quality. The use of the signs is more common in the long-term debt ratings than in short-term debt ratings.

Investors into average-to-low quality (a rating of 3 and above) short-term bond funds are at a disadvantage to long-term bond fund investors. Suppose a long-term debt security is given a rating of D, there is some hope, given the longer maturity, that the company might be turned around or restructured, thereby providing a good return. With short-term bonds, the shorter maturity period means there is less time for such a turnaround.

So investors are advised to invest in short-term bond funds with most debt securities with ratings of 1 and 2. Investors with higher risk appetites may invest in bond funds with debt securities with ratings of 3 or more.