Thin capitalisation: practical guidance: loan pricing and the use of credit ratings: what are credit ratings used for by the market?
Purpose of a credit rating
When a credit rating agency issues a credit rating - see INTM524110 - the rating is a contributory factor in determining what margin a debt instrument should carry over that of a risk free security, such as a government bond issued by a highly rated sovereign state. This enables the debt to be priced correctly. Other factors that affect pricing include:
- the features of that instrument
- the state of the market at the time of issue
- anticipated demand for the instrument
Instruments with the same credit ratings but with different maturity dates or which are issued by companies in different sectors will carry different margins.
Independent ratings are constantly monitored and altered if the risk profile of the issuer changes. This may happen for a number of reasons, for example:
- merger prospects
- revenue shortfalls
- regulatory changes
Once a traded bond has been issued, market forces determine its pricing through the redemption yield (the sum of interest payments due, and the gain/loss when it matures). If the credit rating of the issue is downgraded, then usually the price of the debt will fall (although whether credit ratings are a leading or trailing indicator is a matter of much debate). When the price falls, its redemption yield rises to compensate investors for the increased risk. A deteriorating credit rating will often lead to bond-holders attempting to sell their debts in the market.