A credit rating is a quantitative assessment of a borrower’s creditworthiness in general terms or in relation to a particular debt or financial obligation.
What is a credit rating?
A credit rating can be assigned to any organization that seeks to borrow money – a private person, a corporation, a state or provincial authority, or a sovereign government.
There are 3 main rating agencies that evaluate the creditworthiness of companies: Moody’s, Standard & Poor’s (S&P) and Fitch. They assess the creditworthiness of companies (aka the issuer’s financial ability to pay interest and repay the loan in full on maturity) is what determines the bond’s rating and also affects the yield the issuer must pay to attract investors. Lower-rated bonds typically offer higher yields to compensate investors for the added risk.
Credit ratings scale
Each rating agency uses its own scale, but each of them assigns ratings in the form of a letter assessment to long-term debts. The AAA rating (triple A) is the highest credit rating possible, while the rating at D or C is the lowest.
The rating scale of the top three agencies is illustrated below:
There are additional divisions in the ranking of each agency. For example, S&P assigns + or – to ratings from CCC to AA, indicating a higher or lower level of creditworthiness. For Moody’s, the distinction is made by adding a number between 1 and 3: a Baa2-rated issue is more creditworthy than a Baa3-rated issue and less creditworthy than a Baa1-rated issue.
Investment Grade vs. Non-Investment-Grade
The range of possible credit ratings is divided into two categories: investment and non-investment debt obligations.
Investment grade ratings
Government or corporate borrowers rated BBB to AAA are considered to have an investment grade rating. These are extremely low-risk borrowers who are considered highly likely to meet all their payment obligations. Because there is high demand for their debt, these companies or governments can usually borrow money at very low interest rates.
A BB credit rating or lower indicates a non-investment or speculative level of debt. For these borrowers, the tongue-in-cheek term “junk bonds” is also used, indicating the perceived likelihood that they are at risk of default or have already done so. However, these types of bonds have one advantage: the bondholder is usually paid higher interest.
Factors affecting credit ratings
Credit agencies take into account several factors when compiling a rating of a potential borrower. First, the agency considers the past history of borrowing and repayment of debts by the subject. The history of missed payments, defaults or bankruptcies can negatively affect the rating.
The agency is also looking at the borrower’s cash flows and the current level of debt. If the organization has a stable income and the future looks bright, the credit rating will be higher. If there is any doubt about the economic prospects of the borrower, his credit rating will be lowered.
Here are some of the factors that could affect the credit rating of a company or government borrower:
- Your organization’s payment history, including any missed payments or default defaults.
- The amount they currently owe and the types of debt they have.
- Current cash flows and revenues.
- Market prospects of a company or organization.
- Any organizational issues that may interfere with the timely repayment of debts.
Note that credit ratings suggest some subjective judgments, and even an organization with an impeccable payment history may be downgraded if the rating agency believes that its ability to make payments has changed.
Why credit ratings are important
Credit ratings play a big role in a potential investor’s decision about whether to purchase bonds or not. A low credit score is a risky investment. That’s because it indicates a greater likelihood that the company won’t be able to make repayments on its bonds.
Credit ratings are never static, meaning borrowers must be diligent in maintaining a high credit rating. They are constantly changing on the basis of the latest data, and one negative debt will lead to a decrease in even the highest indicator.
It also takes time to get a loan. An organization with good credit but a short credit history is not viewed as positively as another organization with the same good credit but a longer credit history. Debtors want to know if a borrower can consistently maintain a good loan over time.