Credit Rating Terminology
Credit rating is an important and almost central part of the overall credit risk management function in any organization. Every major organization around the world has implemented credit rating in some form. In many companies, credit rating has been overtaken by credit scoring. Instead of providing a rough range about the creditworthiness of a prospective creditor, it is now possible to know an exact score that helps compare the creditworthiness between two close creditors. In this article, we will understand how to interpret credit ratings in the correct manner.
There are some words that are used to describe a credit rating. It is important to know the meaning of these words since it impacts the credit rating.
Credit Rating Duration
A credit rating is considered to be new when it is created for the first time. Sometimes the credit rating is made public by the company whereas other times, this information is not revealed. However, this rating is not permanent. It is generally subject to an annual review. During the review, the issuer of the rating might upgrade or downgrade the rating. Alternatively, they could leave it unchanged. In most cases, this constitutes a credit event. It is also possible for the credit rating to be withdrawn mid-way. This may happen because the debt has been paid off earlier than expected or has been rolled over. Hence, a withdrawal cannot in itself be considered to be an adverse credit event. The reasons behind the withdrawal have to be looked into in order to decide this. In short credit ratings can be short, medium, or long term.
Credit Rating Watch and Outlook
A credit rating generally consists of two parts. One part defines how the credit of the borrower is as of now whereas the other part describes about how it is expected to be in the future. The future event may be short-term or medium term in nature. The short-term prediction is called credit rating watch whereas the medium term prediction is called credit rating outlook. Here also, credit rating agencies provide negative, positive, and stable ratings which are meant to indicate their beliefs about what the trajectory of the rating is likely to be in the near future.
Credit Rating Qualifiers
Not all credit ratings published by the agencies have the same meaning. The rating agency can publish a lot of different types of ratings. The differentiation related to these types is depicted in the qualifiers that are mentioned along with the ratings. Some examples have been mentioned below:
- PI: A PI rating means that the data related to this rating has been collected from publically available information. This means that the credit rating agency has not done any site visits or has not had access to any primary source of information before releasing the data.
- P: The P rating is intended to describe the level of confidence that the credit rating agency feels about the ability of the borrower to repay the principal portion of the loan. It does not take into account repayment of interest and other charges
- I: Just like the P part, the I part describes the level of confidence regarding the repayment of the interest portion of the loan. This is often used along with the P rating to give the investor a complete picture of the status of their loan
- PR: This type of rating is called a provisional rating and is contingent on another event. For instance, the rating would symbolize the risk involved in running a factory that has not been built yet. It assumes that the factory will be built as expected. It simply mentions the risks which may be relevant after the factory has been built.
Some rating agencies also issue preliminary or expected ratings which are based on the initial information provided to the rating agency. This generally means that the rating process has not been completed as yet.
Solicitation in Ratings
Some borrowers may ask credit rating companies to rate their debt. On the other hand, some borrowers may be rated on the basis of publically available information. This is because they do not prefer to pay for ratings for various reasons. The first type of ratings is called solicited rating whereas the other is called unsolicited rating. It is important to understand the type of rating. This is because solicited ratings are known to be more favorable towards the prospective borrower. This is because of the fact that they are paid for by the borrower and also because rating agencies are given access to more information than what is publically available in the market.
Credit ratings are provided by many rating agencies. Hence, it is entirely possible that one rating agency might look at the debt differently as compared to other rating agencies. This situation is called a split rating. Split ratings often create a conundrum. This is because they confuse all the stakeholders right from regulators to investors. They now have multiple opinions and dont know whom to believe. In such situations, the regulators prescribe that the lower rating be used in case there are two ratings and median rating be used if there are more than two ratings. Investors decide which rating to consider based on their risk policy and their individual risk appetites.
Since there are so many different types of credit ratings, it would be fair to say that credit analysts need to be well versed about each of these types of ratings as well as what they signify. If they are unable to do so, they might not be able to interpret credit events and therefore credit contracts accurately. This could lead to huge losses to the company in the long run.
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