What is a Shadow Rating
A shadow rating in an unofficial rating given to a bond or an issuing party by a credit agency, but without any public announcement of the rating. The shadow rating can serve two purposes. First, it may be helpful to a company that is contemplating issuing rated debt in the market but is unsure about how it would be received. Second, it can serve as a rough guide for issues or issuers that have not been formally rated by a credit agency. Investors who may be interested in purchasing debt (sovereign bonds, for example) that has no official credit rating can integrate the shadow rating in its investment decision process.
BREAKING DOWN Shadow Rating
An issuer that has never been officially rated by a credit agency may approach S&P, Moody's or another agency to obtain shadow ratings for itself and a debt issue in order to test the waters, or get a rough indication of how it may be viewed in the public markets. The credit agency would go through its steps as it would in a formal rating process to assign a credit rating. This shadow rating would provide helpful information to the prospective issuer about the pricing of the debt instrument (i.e., approximate interest expense) in the current market and potential demand given known sets of debt investors. If the shadow rating is favorable, the issuer may be encouraged to proceed with the offering and secure an official rating from the credit agency. If the shadow rating does not meet the issuer's expectations, it can hold off on a formal rating and issuing debt into the market. The option value of a shadow rating is clear, and after the issuer or potential debt issue is vetted by a credit agency, the issuer will have a better understanding of what is necessary to achieve a certain desired rating, whether in how the company generates cash flows or how to structure a debt offering.
If investors are interested in traded debt issues that carry no credit ratings from an agency, they may look to shadow ratings in their evaluation of the creditworthiness of the targeted investment. Investors may engage with a credit agency to perform an analysis, but they also may conduct the exercise themselves using comparable analysis methods. An unrated sovereign, for example, possessing similar characteristics of a rated country could receive the same rating designation as this comp. The shadow rating, then, would assist in the determination by an investor of whether a debt issue is an acceptable investment.