What is a “Credit Rating”?
A credit rating is a unique scoring system that evaluates the default risk of a borrower, being either a corporation or sovereign government, or a particular debt issue. It is very important as it serves investors as guidance for the creditworthiness of the debt issuer and the interest rate at which the loan should be repaid.
There are three major credit rating agencies – Standard and Poor’s, Moody’s and Fitch. Although credit ratings are assessed independently, credit rating agencies are often criticized for conflict of interest as any company or government needs to pay a fee in order to get their debt issue rated.
Key Learning Points
- A credit rating is a quantitative assessment method that determines the creditworthiness of a company or sovereign government, or a specific debt issue
- Credit ratings provide guidance to the perceived default risk involved when making investments and helps frame the required interest rate for the loan repayment
- Credit ratings can be given to both short-term and long-term debt issuances by both corporate and government entities
- Credit ratings are typically divided into two groups – Investment Grade, or Non-Investment Grade (High Yield also known as Junk)
- The “big three” credit rating agencies are Standard and Poor’s, Moody’s and Fitch. Despite following a rigorous process in their assessment, their independence is often questioned as the issuer needs to pay in order to get a rating for its debt
Why are Credit Ratings Important?
Credit ratings are extremely important as they serve as guidance for investors on the quality of a particular bond issue or the issuing body, being corporate or sovereign. A credit rating has a large influence over pricing, interest rates and overall sentiment toward a particular bond as ratings are based on future potential.
There are several factors that are considered in the assessment of a debt issuer or issue. One of the most important components is the company’s (or the sovereign’s) previous history of borrowing and paying off its debt. If there is a history of missed payments or in the worst-case default on debt, this would have a negative impact on the issuer’s credit rating. Other characteristics that are considered in the assessment process include the financial health of the institution in question, its future economic prospects and the overall economic outlook. Credit ratings look closely at the financial commitments of a debt issuer, including leverage, cash flows and other indicators to help categorize its credit rating.
Investment Grade vs. High Yield
Rated bonds are divided into two main categories – Investment Grade and Non-Investment Grade, also known as High Yield or Junk. Generally, the return offered by a bond is benchmarked by its credit rating – higher quality bonds typically offer a lower return as the default risk profile is also lower. Thus the investor’s chances of receiving interest payments and a repayment of their money are very good. As the risk level increases, investors demand higher returns on these perceived lower quality issues to compensate for the higher risk involved with that investment.
Investment Grade bonds are higher rated issues that are deemed more secure and have positive outlook. They capture ratings from “AAA” to “BBB-“ (according to S&P’s methodology) with a good example for AAA rating being the US Treasury Bonds. On the other hand, High Yield bonds are “BB+” rated or below – they are higher risk investments that offer higher yield in order to attract investor’s attention. “Junk” bonds could be further broken down into two sub-categories. Those that once were rated as investment grade, but due to the issuer’s declining credit quality were reduced to high yield are regarded as “fallen angels”, where issuers with improving quality and characteristics, which are on their way to be upgraded to investment grade are called “rising stars”.
Credit ratings are usually updated quarterly, following the reported earnings releases, however longer, more detailed reports tend to be taken annually. If there is a significant shift in a company’s outlook, or a macro event then credit ratings may be reviewed at that time.
Investors keep a close eye on when credit ratings change their ratings either with a ‘downgrade’ or ‘upgrade’ as it can have a material impact on the price of debt. Credit ratings can be updated on both a short-term and long-term outlook.