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Almost all public or quasi-public debt issues must be rated by a credit rating agency, which are firms that specialize in credit analysis and may have access to information which a general investor or shareholder might not have.
Credit ratings have become popular with growth in debt markets, primarily because: (a) they do an independent analysis of risk, (b) they make a comparison between debt easier, (c) are acceptable for regulatory and statutory purposes, and (d) their cost is borne by the issuer. In the aftermath of the 2008-2009 crisis, new legislation is introduced
Following are some of the features of the credit rating nomenclature:
Rating agencies also provide information about their outlook—positive, stable or negative, and potential director of their rating (in certain circumstances) i.e. on review for downgrade, on CreditWatch for an upgrade, etc.
Rating agencies issue two types of ratings: (a) an issuer rating (also called corporate family rating), which assesses general creditworthiness of the issuer and generally applies to its senior unsecured debt, and (b) an issue credit rating (called corporate credit rating), which relates to a specific bond issued by the company. Even though the cross-default provisions, where default on one bond means default on all bonds, implying the default probability is constant, a rating agency considers factors such as ranking in the capital structure to rate an issue rating differently from an issuer rating through a process called notching.
For credit rating, default risk (the likelihood of default) is the primary consideration, but as the default risk increases, priority of payment in the event of default and loss severity becomes important. Structural subordination occurs when in a holding company setup, cash flows and assets of operating subsidiaries are first used to pay subsidiaries’ debt. These factors cause an issue rating to change a notch or two up or down from the issuer rating. This process is called notching and it is more visible in lower-rated credits.
Despite a few exceptions during the financial crisis of 2008-2009, rating agencies have done a good job are assessing credit risk which is why they are very popular. However, they are prone to limitations:
by Obaidullah Jan, ACA, CFA on Tue Feb 18 2020
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