(1) Credit Rating
Credit ratings express a credit rating agency's evaluation of credit risk−the risk that an issuer of a bond may be unable to make timely principal and interest payments. In other words, ratings express the default risk of bonds,
1and not the issuer's growth potential, competitiveness, or business failure risk. Bonds issued by the same issuer can and do receive different credit ratings depending on collateral and other conditions. Above all, credit ratings are not objective data like economic statistics, but subjective evaluations made by credit rating agencies.
Typically, credit ratings are issued on long-term bonds and CP (commercial paper). In addition, there are long-term deposit ratings, bank finance strength ratings, and insurance finance ability ratings. Instruments need not take the form of a bond, but only need to have a future asset flow.
Usually, credit ratings are requested by the bond issuer, and made by the agency after it conducts interviews and exchanges views with the bond issuer. However, agencies can also release ratings unilaterally based on an evaluation of publicly available information such as financial balance sheets.
1 Default is when an issuer of a bond is unable to make timely principal and interest payments. Since default includes deferred repayment, partial repayment, and complete nonpayment, it does not necessarily imply bankruptcy.
(2) Credit Rating Agencies
Japan presently has eight credit rating agencies designated by the Ministry of Finance. Three are domestic−Japan Bond Research Institute (JBRI), Nippon Investors Service ( NIS), and Japan Credit Rating Agency (JCR). The other five are foreign−Moody's, Standard & Poor's, Fitch IBCA, Duff & Phelps, and Thomson Bankwatch. A credit rating from these designated agencies is required under the shelf registration system.
2There are also non-designated agencies such as Mikuni & Co. who are oriented toward investors. Consolidation has been occurring in the industry as international competition intensifies; Fitch IBCA was formed last year in a merger between Fitch and IBCA, while JBRI and NIS are scheduled to merge in April.
2 Under shelf registration, companies that meet credit rating and other conditions must submit a shelf registration statement describing details such as the type of bond to be issued and amount. Then for one to two years after registration, they can issues bonds at will using simplified procedures.
(3) Users of Credit Rating Data
Credit rating data is used by both bond investors and issuers.
For bond investors, the merits of credit rating data are: (1) savings in research costs, and (2) ratings represent the informed opinion of a neutral third party. Unlike stocks, bonds have a cash flow that is ultimately repaid, and it is usually difficult to obtain large capital gains. Spending too much on credit risk research diminishes the return on investment. In addition, unlike underwriters and main banks, credit rating agencies are valued for their neutral viewpoint and expertise in credit risk analysis. For these reasons, bond investors rely heavily on credit rating data.
For the bond issuer, the merits of credit ratings are: (1) expanded access to capital markets, and (2) lower financing cost. By adopting a universally accepted measure of credit risk, issuers of any nationality can gain access to global capital markets. In addition, since the issuer's credit risk is publicly announced, the issuer can obtain financing at an appropriate interest rate and avoid unnecessary credit spreads that may arise from misinformation or lack of recognition.
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Thus both bond investors and bond issuers rely on credit rating agencies. Investors−mainly institutional investors−pay to obtain the rating data, while bond issuers pay to be rated. By receiving income from both investors and issuers, credit rating agencies are able to maintain neutrality.
3 Interest-bearing assets such as bonds are discussed in terms of yields rather than prices. Since bond yields reflect risks associated with bonds, we can analyze the yield spread between corporate bonds, which have a default risk, and government bonds, which do not, to find the market's valuation and investors' preferences toward default and other credit risk.
(4) History of Credit Rating
Credit ratings originated spontaneously in the U.S. during the 19th century, when huge amounts of railroad and business bond issues attracted investors not only in the U.S. but Europe. To protect themselves from frequent bond defaults, investors turned to bond publications for credit risk information. The alphabet letter notations developed at that time exist to this day.
In Japan, efforts to establish credit ratings in bond markets began in 1979 with the introduction of credit ratings as part of the bond issue (qualification) standards. The standards were intended to protect creditors (investors) by requiring issuers of unsecured bonds to satisfy strict credit rating and financial standards. These restrictions ensure that all bond issues on the market come from reputable issuers with a superior credit risk. The standards were eased several times before finally being abolished in 1996. Today, bonds of various ratings exist on the market, and investors must be accountable for their own decisions. Thus credit ratings in Japan have actually been used in their true sense for only two years.