Credit risk is the possibility of a debt default due to the borrower's failure to make necessary payments. Sovereign government debt is typically seen as having no credit risk.

The ability to repay the borrowed funds, as well as the interest component, must be evaluated to determine the price and return of non-government debt instruments.

Debt investments are typically illiquid and long-term investments. Investors must therefore receive complete disclosures, both required and voluntary, about the issuer and the issue. A competent and objective agency that can offer an independent view of the potential future performance of the debt is necessary to standardise and summarise the extensive information about the issuer and the issue.

What is Credit Rating?

A credit rating is an opinion from a credit rating agency about the ability and willingness of any company or entity to meet its financial obligation on time and in full.

A credit rating also shows how likely a debtor will not pay back what they owe. It's also a measure of the credit risk that comes with a debt asset, like a loan or bond.

Credit ratings may be obtained to rate government and corporate bonds, certificates of deposit, commercial papers, municipal bonds, preferred stock, mortgage-backed securities, and collateralized debt obligations, among others.

As per SEBI governance standards: "AAA" for the highest safety, "D" for a default, and many other grades in between.

Any deterioration in the financial capability of the borrower may result in delinquency, either in part or in full. Hence, these ratings are given by an independent entity called a 'Credit Rating Agency'.

A Credit Rating Agency is a company that provides information about the riskiness of a debt instrument or a company in terms of its promised performance of a debt instrument.

The Securities and Exchange Board of India governs these credit rating agencies via SEBI (Credit Rating Agencies) Regulation, 1999, and has defined a credit rating agency as "a body corporate, which is engaged in or proposes to be engaged in the business of rating of securities listed or proposed to be listed on a stock exchange recognised by the SEBI."

These agencies assess the creditworthiness of the borrower from time to time, and may upgrade or downgrade the ratings of the borrowers based on certain parameters.

An issuer must obtain a rating from any of the major credit rating agencies in India before they issue any securities as per SEBI regulation.

Investors typically see the rating before they invest in a debt instrument.

These credit rating agencies, while giving the rating on a debt instrument, will issue the letter grades for each instrument with a Rating Symbol prefix.

Advantages of Credit Rating

Fair rating by independent evaluator: Investors value independent credit rating agencies' risk assessments.

Ease of understanding a company's creditworthiness: Credit rating agencies collect information about the company from public and private domains to produce simplified creditworthiness. The credit rating agency simplifies complex data and information for investors.

Instrument riskiness: Credit Rating provides relative riskiness of the instrument in clear form and guides the market about any rating downgrade or upgrade at regular intervals.

Comparative investment choice: Credit rating helps investors choose between comparative investments by identifying risk, issuer credibility, independent opinion and view about a potential risk, wider choice, saving time and resources for understanding instrument riskiness, and benefits of intensive surveillance by the rating agency.

Builds a company's image: Rated instruments make it easy to sell debt, cut borrowing costs, open a wider market, help create the company's image, and are especially helpful to new and unknown business firms.

Comparison with other countries' instruments: Global investors can simply compare rated securities and assess debt instrument risk.

Sources: Securities and Exchange Board of India, Clearing Corporation of India Ltd, CRISIL LtdRE