Credit Rating: What It Is and Why It’s Important to Investors

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Credit Rating: What It Is and Why It’s Important to Investors

What Is a Credit Rating?

A credit rating is a quantitative evaluation of a borrower’s creditworthiness in general or in relation to a specific debt or financial obligation. Any entity seeking to borrow money may be issued a credit rating, including a person, a business, a state or provincial body, or a sovereign government.

Individual credit scores are determined on a three-digit numerical scale by credit bureaus such as Experian, Equifax, and TransUnion using a version of Fair Isaac Corporation (FICO) credit scoring. A credit rating organization, such as S&P Global, Moody’s, or Fitch Ratings, calculates credit ratings for firms and governments. The entity obtaining a credit rating for itself or one of its debt issues pays these rating companies.

Key Takeaways

  • A credit rating is a quantitative evaluation of a borrower’s creditworthiness in general or in relation to a financial obligation.
  • Credit ratings influence whether a borrower is authorized for credit and the interest rate at which it is repaid.
  • Any entity that want to borrow money is given a credit rating or score, whether it is a person, a business, a state or provincial body, or a sovereign government.
  • Credit bureaus score individual customers’ credit on a numeric scale based on the FICO calculation.
  • Credit agencies assess bonds issued by corporations and governments on a letter-based scale ranging from AAA to D.

Credit Rating

Understanding Credit Ratings

A loan is a debt—basically, a contractual guarantee. A credit rating predicts whether a borrower will be willing and able to repay a loan within the terms of the agreement without defaulting.

A good credit rating implies that a borrower is likely to repay the loan in full, while a low credit rating indicates that the borrower may struggle to make payments. Just as an individual credit score is used to assess a single person’s creditworthiness, companies utilize credit ratings to show their trustworthiness to potential lenders.

Credit Ratings vs. Credit Scores

Individuals, corporations, and governments all have credit ratings. Sovereign credit ratings, for example, apply only to national governments, while corporate credit ratings only apply to firms. Credit scores, on the other hand, are exclusively applicable to people.

Credit scores are obtained from credit-reporting organizations such as Equifax, Experian, and TransUnion’s credit histories. A person’s credit score is given as a number, which typically ranges from 300 to 850.

A borrower’s short-term credit rating represents the risk that he or she will fail within a year. In recent years, this form of credit rating has become the standard, although in the past, long-term credit ratings were more strongly weighted. Long-term credit ratings forecast the borrower’s chance of default at any point in the far future.

Letter grades are frequently assigned by credit rating organizations to denote ratings. For example, S&P Global has a credit rating system that ranges from AAA (outstanding) through C and D. A financial instrument with a rating lower than BB is classified as speculative-grade or junk bond, implying that it is more likely to fail on debts.

A Brief History of Credit Ratings

In 1909, Moody’s released publicly accessible credit ratings for bonds, and other agencies followed suit in the decades that followed. These ratings had little impact on the market until 1936, when a new law prohibiting banks from investing in speculative bonds (bonds with low credit ratings) was enacted.

The goal was to prevent default, which may result in financial damages. Other businesses and financial organizations rapidly copied this technique. Eventually, reliance on credit ratings became the norm.

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Moody’s, S&P Worldwide, and Fitch Ratings control practically all of the global credit rating business.

Fitch Ratings

In 1913, John KnowlesFitch established the Fitch Publishing Company, which provided financial information for the investment business via “The Fitch Stock and Bond Manual” and “The Fitch Bond Book.” Fitch devised and established the AAA through D rating system in 1924, which has since been the industry standard.

Fitch Ratings amalgamated with IBCA of London, a subsidiary of Fimalac, S.A., a French holding firm, in the late 1990s with intentions to create a full-service worldwide rating agency. Thomson BankWatch and Duff & Phelps Credit Rating Co. were also bought by Fitch.

With the purchase of a Canadian firm, Algorithmics, and the formation of Fitch Solutions and Fitch Learning in 2004, Fitch began to build operational subsidiaries specialized in corporate risk management, data services, and finance-industry training.

Moody’s Investors Service

In 1900, John Moody and Company released Moody’s Manual of Industrial and Miscellaneous Securities. The guidebook included basic data and general information on numerous industries’ stocks and bonds.

Moody’s Manual was a nationwide periodical from 1903 to the stock market crisis of 1907. Moody’s started releasing Moody’s Analyses of Railroad Investments in 1909, which included analytical information regarding the value of securities.

Extending on this concept resulted in the establishment of Moody’s Investors Service in 1914, which would offer ratings for practically all of the government bond markets at the time during the next ten years. By the 1970s, Moody’s had expanded into a full-service rating business, evaluating commercial paper and bank deposits.

S&P Global

Henry Varnum Poor released the History of Railroads and Canals in the United States in 1860, foreshadowing the development of securities research and reporting over the following century. The Standard Statistics Bureau, founded in 1906, produced ratings for corporate bonds, government debt, and municipal bonds. In 1941, Standard Statistics and Poor’s Publishing amalgamated to establish Standard & Poor’s Corporation.

Standard & Poor’s Corporation was purchased by the McGraw-Hill Companies in 1966, and the firm was renamed as S&P Global in 2016. It is most known for indexes like as the S&P 500, which was launched in 1957 and is both a tool for investor research and decision-making as well as a US economic indicator.

Importance of Credit Ratings

Credit ratings for debtors are based on extensive due diligence performed by rating agencies. Though a borrowing company would seek for the best credit rating possible since it has a significant influence on interest rates charged by lenders, rating agencies must take a balanced and objective perspective of the borrower’s financial status and ability to service and repay the loan.

A borrower’s credit rating influences not only whether or not they will be authorized for a loan, but also the interest rate at which the loan must be returned. Because businesses rely on loans to cover many beginning and other expenditures, being rejected a loan might mean catastrophe, and a high-interest loan is far more difficult to repay. A borrower’s credit rating should be considered while deciding which lenders to approach for a loan. Someone with excellent credit will most likely find a different lender than someone with fair or even low credit.

Credit ratings can play a significant impact in a prospective investor’s choice to acquire bonds. A low credit score is a dangerous investment. This is because it suggests a greater likelihood that the corporation may be unable to meet bond payments.

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Credit scores are never static, therefore borrowers must work hard to keep their credit rating good. They are constantly changing depending on the most recent data, and one bad debt may drag down even the finest score.

Credit also takes time to accumulate. A company with strong credit but a short credit history is not seen as favorably as a company with similarly good credit but a longer credit history. Debtors want to know whether a borrower can consistently retain excellent credit over time.

Given the importance of maintaining a high credit rating, it’s worth researching the top credit monitoring services and maybe opting for one to keep your information secure.

AA+

On August 5, 2011, Standard & Poor’s downgraded the United States’ credit rating from AAA (outstanding) to AA+ (excellent). Following the downgrading, global stock markets fell for many weeks.

Credit Ratings Scale

While each rating agency has a somewhat different system, they all give long-term debt ratings as a letter grade. A credit rating of AAA is the best achievable, while a rating of D or C is the lowest.

The following are the long-term debt rating scales from the three major agencies:

Credit Ratings Scale: Highest to Lowest
Standard & PoorsMoody’sFitchRatings
AAAAaaAAA
AAAaAA
AAA
BBBBaaBBB
BBBaBB
BBB
CCCCaaCCC
CCCaCC
CCC
DRD
D

There are further categories in each letter rating. For grades between CCC and AA, S&P awards a + or -, reflecting a slightly greater or lower degree of creditworthiness. Moody’s makes the difference by adding a number between 1 and 3: A Baa2 rating is somewhat more creditworthy than a Baa3 rating, but significantly less so than a Baa1 rating.

Investment Grade vs. Speculative Ratings

There are two types of credit ratings: investment-grade debt and non-investment-grade debt.

Investment-Grade Ratings

Investment-grade credit is defined as government or corporate debtors with ratings ranging from BBB to AAA. These are very low-risk borrowers who are expected to satisfy all of their payment commitments. Because their debt is in great demand, these corporations or governments can often borrow money at exceptionally cheap interest rates.

Non-Investment Ratings

A credit rating of BB or below implies that the debt is not of investment or speculative grade. These debtors are also referred to as “junk bonds,” signifying the expected chance that they would fail or have already done so. However, these bonds do have one advantage: they often pay more interest to bondholders.

Factors That Affect Credit Ratings

When grading a prospective borrower, credit institutions take into account a number of characteristics. First, an agency evaluates the entity’s previous borrowing and debt repayment history. Missed payments, defaults, or bankruptcies may all have a negative influence on your credit rating.

In addition, the agency considers the borrower’s cash flows and existing debt levels. The credit rating will be better if the firm has consistent revenue and the future seems promising. If the borrower’s economic forecast is questioned, their credit rating will suffer.

Some of the elements that might affect a company’s or government borrower’s credit rating are as follows:

  • The payment history of the organization, including any missing payments or defaults.
  • The amount they owe now, as well as the categories of debt they have.
  • Current cash flows and income.
  • The company’s or organization’s market forecast.
  • Any organizational obstacles that may prohibit timely debt repayment.
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It is important to note that credit ratings contain some subjective assessments, and even a company with a perfect payment history might be lowered if the rating agency considers that its capacity to make repayments has altered.

For example, in reaction to Congressional bottlenecks that may have resulted in a default, Standard & Poor’s downgraded the credit rating of US national bonds from AAA to AA+ in 2011. Even though the government eventually fulfilled all of its obligations on schedule, the mere mention of nonpayment caused a more pessimistic attitude on US government debt.

Frequently Asked Questions

What’s the Difference Between Credit Ratings and Credit Scores?

Businesses and governments both have credit ratings. Sovereign credit ratings, for example, apply only to national governments, and corporate credit ratings only to firms. Letter grades are frequently assigned by credit rating organizations to denote ratings. For example, S&P Global has a credit rating system that ranges from AAA (outstanding) through C and D. Credit scores, on the other hand, are exclusively applicable to people and are reported as a number ranging from 300 to 850.

Why Are Credit Ratings Important?

Credit ratings or credit scores are based on extensive due diligence by rating organizations, which must take a balanced and impartial perspective of the borrower’s financial status and ability to service/repay the loan. This may affect not just whether a borrower is authorized for a loan, but also the interest rate at which the loan must be returned.

Credit ratings can play a significant impact in a prospective investor’s choice to acquire bonds. A low credit rating makes for a riskier investment since the likelihood of the firm defaulting on bond payments is increased.

What Does a Credit Rating Tell an Investor?

A borrower’s short-term credit rating represents the risk that he or she will fail within a year. In recent years, this form of credit rating has become the standard, although in the past, long-term credit ratings were more strongly weighted. Long-term credit ratings forecast the borrower’s chance of default at any point in the far future. A financial instrument with a rating lower than BB is classified as speculative-grade or junk bond, implying that it is more likely to fail on debts.

What Factors Affect an Individual’s FICO Score?

The FICO score of a person is composed of five components, each with its own weight. Payment history (35%), amounts outstanding (30%), duration of credit history (15%), new credit (10%), and credit kinds (10%) are the criteria. It is crucial to remember that FICO ratings do not include age, but they do examine the duration of one’s credit history.

The Bottom Line

Credit ratings are the business counterpart of a credit score. Debts owed by businesses or governments are assessed on a range of D to AAA rather than the 300-850 scale used for individual FICO scores. These credit scores demonstrate a borrower’s ability to make timely payments. A poor credit rating might result in higher interest rates on a borrower’s debts, resulting in bigger financial problems in the future.

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