Credit Rating: Definition and Importance to Investors

What Is a Credit Rating?

A credit rating is an independent assessment of the ability of a corporation or a government to repay a debt, either in general terms or regarding a specific financial obligation.

Credit scores are assigned to individuals based on their personal history of acquiring and repaying debt. They are checked by lenders considering loaning money to a consumer.

Credit ratings are issued to companies and governments by several companies including S&P Global,Moody's, and Fitch Ratings. Credit ratings are used by investors who want to know the risk of buying bonds or other debt instruments issued by these entities.

Understanding Credit Ratings

Credit ratings are an estimate of the level of risk involved in lending money to a 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 low credit rating suggests it might struggle to make its payments. The lowest ratings indicate the borrower is in real financial trouble.

Bonds receive credit ratings before they are issued. The interest they pay is based on the credit rating they receive. A lower-rated company is forced to pay a higher interest rate to compensate for the risk of the investment.

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.

Credit ratings 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 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. 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 Knowles Fitch founded 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 in 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 it did not rate them.

In 1909, Moody began publishing "Moody's Analyses of Railroad Investments" and, for the first time, rated many railway company securities. 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 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 form Standard & Poor's Corporation.

Standard & Poor's Corporation was acquired by the McGraw-Hill Companies in 1966, and the company rebranded as S&P Global in 2016. 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 has 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. In general, 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:

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 each has its own formula. In general, the major factors that influence the credit rating are:

• 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.

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.