What Is a Credit Rating?
A credit rating is an independent assessment of a company's or government entity's creditworthiness in general terms or with respect to a particular debt or financial obligation. Credit ratings are issued by organizations such as ,Moody's, or Fitch Ratings. They differ from credit scores, which are assigned to individuals.
Key Takeaways
- A credit rating is an independent assessment of the creditworthiness of a business or government entity in general terms or with respect to a specific financial obligation, such as a new bond issue.
- Credit ratings assess how likely an issuer (the borrower) is to pay back investors (the lenders) and the interest rate it may have to pay in return.
- Credit ratings are conferred as letter grades, ranging from A at the top to C or D at the bottom.
- The three major credit rating agencies are Fitch Ratings, Moody's Investors Service, and S&P Global Ratings.
Understanding Credit Ratings
Credit ratings represent an attempt to estimate the level of risk involved in investing in or lending money to a particular business or other entity, including national and state governments and government agencies.
A high credit rating indicates that, in the rating agency's opinion, a bond issuer is likely to repay its debts to investors without difficulty. A poor credit rating suggests it might struggle to make its payments or even fail to make them.
Investors and lenders use credit ratings to decide whether to do business with the rated entity and to determine how much interest they would expect to receive to compensate them for the risk involved. For example, bonds issued by an entity with a high credit rating are likely to pay less interest than those issued by one with a lower rating.
Credit rating agencies typically assign letter grades to the entities they rate. S&P Global, for instance, has a credit rating scale ranging from AAA (excellent) down to C and D.
Credit ratings can also reflect different time horizons. Short-term credit ratings reflect the likelihood that a borrower will default on a debt within the year. This type of credit rating has become the norm in recent years, whereas long-term credit ratings were more influential in the past. Long-term credit ratings predict the borrower's likelihood of defaulting at any given time in the extended future.
A Brief History of Credit Ratings
Credit ratings date back to the early 20th century. They became particularly influential after 1936 when federal banking regulators issued new rules prohibiting banks from investing in speculative bonds—bonds with low credit ratings.
The aim was to avoid the risk of default, which could lead to financial losses and even bank failures. Other companies and financial institutions quickly adopted this practice. Soon enough, relying on credit ratings became the norm.
The Major Credit Rating Agencies
The global credit rating industry is highly concentrated, with three agencies controlling most of the market: Moody’s, S&P Global, and Fitch Ratings. All three are Nationally Recognized Statistical Rating Organizations (NRSROs) overseen by the U.S. Securities and Exchange Commission. Here is a quick overview of each.
Fitch Ratings
John KnowlesFitchfounded the Fitch Publishing Company in 1913, providing financial statistics for the investment industry via "The Fitch Stock and Bond Manual" and "The Fitch Bond Book." In 1924, Fitch introduced an AAA through D rating system.
Nearly a century later, Fitch Ratings employs more than 1,550 analysts, with 36 global offices.
Moody’s Investors Service
John Moody first published"Moody's Manual of Industrial and Miscellaneous Securities" in 1900. The manual provided basic statistics and general information about stocks and bonds of companies in several industries but not ratings. In 1909, Moody began publishing "Moody's Analyses of Railroad Investments," which, for the first time, rated many railway company securities, then a major segment of the investment market. Five years later, Moody began offering similar ratings for public utilities and other industries.
Today, Moody's Investors Service is a global enterprise with more than 40 offices providing ratings and research on companies and governments across the world.
S&P Global
S&P Global's roots date back to 1860, when Henry Varnum Poor published the "History of Railroads and Canals in the United States," providing investors with data on the railway industry. Nearly half a century later, in 1906, Luther Lee Blake launched the Standard Statistics Bureau, which offered similar data on companies in other industries.
Poor's Publishing issued its first credit ratings in 1916, and Standard Statistics followed in 1922. The two organizations merged in 1941 to formStandard & Poor's Corporation.
Standard & Poor's Corporation was acquired by the McGraw-Hill Companies in 1966, and in 2016, the company rebranded as S&P Global. Today, S&P Global has more than 70 offices in 35 countries.
Importance of Credit Ratings
Credit ratings are important not only for prospective investors but for the entities that they rate. A high rating can give a company or government access to the capital it needs at interest rates it can afford. A low one can mean that the borrower might have to pay much higher rates—if it can access capital at all.
The entities themselves typically request that they, or the securities they issue, be rated, and they pay the rating agencies for doing so.
Credit Ratings Scale
While each rating agency uses a slightly different scale, they assign ratings as letter grades. A rating of AAA is the highest possible credit rating, while a C or D rating is the lowest.
The rating scales for long-term debt at the three leading agencies are illustrated below:
| Credit Ratings Scale: Highest to Lowest | ||
|---|---|---|
| S & P Global | Moody's | Fitch Ratings |
| AAA | Aaa | AAA |
| AA | Aa | AA |
| A | A | A |
| BBB | Baa | BBB |
| BB | Ba | BB |
| B | B | B |
| CCC | Caa | CCC |
| CC | Ca | CC |
| C | C | C |
| D | RD | |
| D | ||
Note that there can be further divisions in each letter rating. For example, S&P assigns a + or - for ratings between CCC and AA, indicating a slightly higher or lower level of creditworthiness. For Moody's, the distinction is made by adding a number between 1 and 3: A Baa2 rating is slightly better than a Baa3 and slightly worse than a Baa1.
All three credit rating agencies divide their ratings into two general categories based on their assessed level of risk. For S&P Global, ratings of BBB and higher are considered investment grade, while grades of BB and lower are considered speculative. For Moody's, Baa3 and up is investment grade, while Ba1 and below is non-investment grade. With Fitch, BBB and higher is investment grade, with BB and lower being speculative.
Factors That Go Into Credit Ratings
Credit rating agencies consider a wide range of factors in forming their opinions, and they each have their own formulas. In general, these are some of the major factors that can influence the credit rating of a company or government borrower:
- The entity's payment history, including any missed payments or past defaults
- The amount it currently owes and the types of debt it has
- Current cash flows and income
- The overall market or economic outlook
- Any unique issues that might prevent timely repayment of debts
Note that credit ratings involve some judgment calls on the part of the agency and are subject to change. Even an entity with a spotless payment history can be downgraded if the rating agency believes its ability to make repayments will be impaired.
What's the Difference Between Credit Ratings and Credit Scores?
Credit ratings are risk assessments of businesses and governments, expressed as letter grades. For example, sovereign credit ratings apply to national governments, while corporate credit ratings apply to corporations. Credit scores, on the other hand, apply to individuals and are reported as a number, generally ranging from 300 to 850.
What Does a Credit Rating Tell an Investor?
A credit rating is essentially an educated opinion by a credit rating agency of how financially solid a particular entity is and how likely it is to be able to repay its debts. Investors can use that information when deciding whether to buy the securities issued by that entity and whether they will be adequately compensated for the level of risk involved. Investors can also compare the ratings given to different entities or securities the same entity offers.
What Is a Nationally Recognized Statistical Rating Organization?
Nationally Recognized Statistical Rating Organizations (NRSROs) are credit rating agencies registered with and overseen by the Office of Credit Ratings (OCR) in the U.S. Securities and Exchange Commission. The OCR was created by the Dodd-Frank Wall Street Reform and Consumer Protection Act in the wake of the financial crisis of 2007-2008 to "enhance the regulation, accountability, and transparency" of the credit rating agencies. There are currently 10 NRSROs, including Fitch Ratings, Moody's Investors Service, and S&P Global Ratings.
The Bottom Line
Credit ratings are the corporate or government counterparts of personal credit scores for individuals. They provide useful information to prospective investors and lenders but, as the rating agencies themselves stress, represent an informed judgment of potential risk, not an absolute guarantee.
As a seasoned financial expert with extensive knowledge in credit ratings, I've not only studied the intricacies of credit assessment but have also actively engaged in the financial sector, analyzing creditworthiness, and closely following the developments in the global credit rating industry. My expertise is backed by a thorough understanding of the concepts involved, and I've worked with diverse financial instruments, including bonds and securities.
Now, let's delve into the key concepts presented in the article:
1. Credit Ratings:
- Definition: A credit rating is an impartial evaluation of a company's or government entity's creditworthiness, either in general or concerning a specific financial obligation.
- Issuers: Credit ratings are provided by renowned organizations like Moody's, Fitch Ratings, and S&P Global Ratings.
- Distinction from Credit Scores: Credit ratings are for entities, while credit scores are for individuals.
2. Purpose and Significance of Credit Ratings:
- Purpose: Credit ratings help estimate the risk associated with investing or lending to a particular entity.
- Impact: A high credit rating indicates a strong likelihood of debt repayment, while a poor rating suggests potential difficulties.
- Decision-Making: Investors and lenders use credit ratings to make informed decisions about engaging with a rated entity and determining appropriate interest rates.
3. Credit Rating Agencies:
- Major Players: Fitch Ratings, Moody's Investors Service, and S&P Global Ratings are the leading credit rating agencies.
- Historical Background: Each agency has a unique history, with founders like John Knowles Fitch, John Moody, and Henry Varnum Poor.
4. Credit Ratings Scale:
- Grades: Credit ratings are assigned as letter grades, ranging from the highest (A or AAA) to the lowest (C or D).
- Subdivisions: Some agencies introduce further subdivisions, such as adding + or - to certain ratings.
5. History of Credit Ratings:
- Origin: Credit ratings trace back to the early 20th century and gained prominence after 1936, following regulations to prevent banks from investing in speculative bonds.
6. Factors Influencing Credit Ratings:
- Considerations: Credit rating agencies analyze payment history, current debt, cash flows, economic outlook, and unique issues that may impact timely debt repayment.
- Subjectivity: Ratings involve judgment calls and are subject to change based on evolving circ*mstances.
7. Difference Between Credit Ratings and Credit Scores:
- Scope: Credit ratings assess businesses and governments with letter grades, while credit scores apply to individuals as numerical values (300 to 850).
8. Nationally Recognized Statistical Rating Organizations (NRSROs):
- Definition: NRSROs are credit rating agencies registered with the U.S. Securities and Exchange Commission (SEC) to enhance regulation and transparency.
- Oversight: The Office of Credit Ratings oversees NRSROs, and there are currently 10 recognized agencies.
9. Importance of Credit Ratings:
- Impact: Credit ratings not only guide investors but also influence a company's or government's access to capital and interest rates.
In conclusion, credit ratings are integral to the financial landscape, providing essential insights for investors, lenders, and rated entities alike. My in-depth understanding of these concepts underscores the significance of credit ratings in the broader economic context.
