Meaningful Minutes

What are credit ratings:

Ratings agencies like Moody’s regularly evaluate a company or financial instruments like bonds to judge its worthiness on the basis of the debt, the ability to pay back, financial strength and other factors. There are three kinds of ratings – credit, debt, and financial strength ratings. For a country, agencies decide the rating of its foreign currency bond, called the sovereign bond. Apart from ratings, the agencies also issue whether the outlook is stable or negative. This indicates the likelihood of a downgrade or upgrade in the near future.

What causes downgrades or upgrades:

Ratings agencies regularly monitor the financial performance of companies and countries. They monitor positive trends or stress factors to forecast the near-term outlook of an institution.

In the case of SBI, Moody’s cited two key factors – stress on the quality of loans due to the persistent slowdown in the economy, and high reliance on capital infusion by government. According to the agency, negative factors like rupee depreciation, high inflation and high interest rates further cut down chances of an upgrade in the future as they will hinder growth in demand, and affect profitability.

How it affects stock markets

Stock markets bet on the financial health of a company. An investor wants to put his money in a company which has greater chances of success. But, there are a variety of companies to pick from. Comparing different kinds of institutions is often very difficult because different industries operate in different ways. You need a common yardstick to measure these against. An agency rating is one such yardstick.

A ratings downgrade or upgrade gives an indication to investors about the company’s potential to make more profits without accumulating too much deb.

Shares in SBI have tanked since the repo rate hike announced by the RBI last Friday. Adding to the pressure on stocks is the rating downgrade. Since then, share price is down nearly 7%, extending its slump of nearly 30% year to date.

What it implies

A ratings and an outlook downgrade is not a good sign. ‘Baa3’ is the lowest in the set of investment-grade ratings of that agency. If there is a downgrade, it means that, the risk in lending to that company is higher. This means investors will be willing to provide funding at higher costs. Any further fall means a junk rating. This will make it difficult for the institution to raise foreign debt. Even if it manages to raise any funds, it will come at exorbitant cost. SBI, however, tried to ease worries and said the ratings downgrade will not affect its plans to raise funds locally or internationally.

Not always right

Ratings agencies raise red flags. That does not mean that they get it right all the time. For example, no rating agency predicted the US housing debt crisis. This means they have to be conservative, and at times, skeptical. This is why it is easier to be downgraded than upgraded.