INTM524030 - Thin capitalisation: practical guidance: 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 INTM524010 - the rating is a contributory factor in determining what spread a debt instrument should carry over that of a risk free security, such as a government bond issued by a highly rated sovereign state. Other factors that affect pricing include:

• the features of that instrument (in particular amount, maturity and currency)
• the state of the market at the time of issue against the microeconomic backdrop
• anticipated lending demand for the instrument

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 debt has been issued, market forces determine its pricing through the supply-demand relationship between borrowers and lenders. Lenders determine what their appetite is for a particular combination of amount and maturity. There is an inherent tension in the relationship between amount and maturity such that larger amounts tend to be lent for shorter maturities for a particular credit-risk level of borrower. The interest that such combinations attract will be determined by the prevailing macroecoomic conditions, the credit risk of the borrower and various other factors such as the terms of the debt, in particular its seniority.