Credit ratings play a crucial role in assessing the creditworthiness of companies, government entities, and other borrowers. This article provides an overview of credit ratings, their significance, and the major credit rating agencies responsible for issuing them.
What Are Credit Ratings?
Credit ratings represent an independent evaluation of an entity’s ability to fulfil its financial obligations. They are typically assigned by organisations such as S&P Global, Moody’s, and Fitch Ratings. Unlike credit scores, which apply to individuals, credit ratings focus on the creditworthiness of businesses and governments.
Importance of Credit Ratings:
Credit ratings help investors and lenders gauge the risk associated with investing in or lending money to a particular entity. A higher credit rating suggests a lower risk of default, indicating that the borrower is more likely to repay its debts. Conversely, a poor credit rating indicates a higher risk, implying potential difficulties in meeting payment obligations.
The Use of Credit Ratings:
Investors and lenders rely on credit ratings to make informed decisions about engaging with a rated entity. These ratings also influence the interest rates offered to borrowers. Bonds issued by entities with higher credit ratings typically yield lower interest rates compared to those with lower ratings.
Differentiating Short-term and Long-term Credit Ratings:
Credit ratings can have different time horizons. Short-term credit ratings assess the likelihood of default within a year, while long-term ratings predict default probabilities in the extended future. In recent years, short-term ratings have gained prominence over long-term ratings.
The Historical Context of Credit Ratings:
Credit ratings originated in the early 20th century, gaining significant influence after 1936 when federal banking regulators prohibited banks from investing in bonds with low credit ratings. This practice was adopted by various institutions, establishing credit ratings as a standard evaluation tool.
Major Credit Rating Agencies:
The global credit rating industry is dominated by three major agencies: Moody’s, S&P Global, and Fitch Ratings. These organisations are designated as Nationally Recognized Statistical Rating Organizations (NRSROs) and regulated by the U.S. Securities and Exchange Commission.
Founded in 1913, Fitch Ratings provided financial statistics through publications like “The Fitch Stock and Bond Manual.” Today, Fitch Ratings operates globally with over 4,500 employees and numerous offices worldwide.
Moody’s Investors Service:
John Moody published the first Moody’s Manual in 1900, initially providing general information about stocks and bonds. Over time, Moody introduced ratings for railway investments and expanded into various industries. Presently, Moody’s is a globally recognised organisation with offices across the world.
Henry Varnum Poor’s publication on railroads in 1860 marked the beginning of S&P Global’s history. The organisation expanded its coverage to other industries in 1906 through the Standard Statistics Bureau. In 1941, Poor’s Publishing merged with Standard Statistics to form Standard & Poor’s Corporation, which later rebranded as S&P Global. Today, S&P Global operates in numerous countries with a wide presence.
Importance of Credit Ratings:
Credit ratings hold significant importance for both lenders/investors and the entities being rated. A favourable credit rating provides access to affordable capital, while a lower rating can result in higher borrowing costs or limited access to funds.
Benefits for Borrowers:
For companies and governments, credit ratings are crucial as they influence the interest rates at which they can borrow money. A high credit rating increases the likelihood of obtaining capital at favourable rates, enabling efficient financing of operations, investments, and projects. It enhances its reputation and demonstrates a strong track record of fulfilling financial obligations.
Requesting Credit Ratings:
Entities themselves often seek credit ratings for themselves or their issued securities, recognising the benefits it brings. These entities approach rating agencies and pay for the assessment of their creditworthiness.
Credit Rating Scale:
Although rating agencies utilise slightly different scales, they assign ratings using letter grades. The highest credit rating is typically represented as AAA, indicating exceptional creditworthiness. Conversely, ratings in the C or D range represent the lowest creditworthiness.
|Credit Rating Scale: Highest to Lowest|
|S & P Global||Moody’s||Fitch Ratings|
Note that each of the major credit rating agencies further divides their ratings into more specific categories based on the level of creditworthiness. These additional divisions provide a finer distinction within the letter rating range.
S&P Global Ratings, for example, includes a “+” or “-” sign for ratings between CCC and AA. This indicates a slightly higher or lower level of creditworthiness within the respective letter rating. For instance, a rating of AA+ is slightly better than AA, while AA- is slightly lower.
Moody’s differentiates its ratings by adding a number between 1 and 3. For example, a Baa2 rating is slightly better than a Baa3 but slightly worse than a Baa1. This numerical distinction provides more granularity within a specific letter rating.
Fitch Ratings follows a similar approach, designating ratings of BBB and higher as investment grade, while ratings of BB and lower fall under the speculative category.
These additional divisions within the letter rating range allow for a more nuanced assessment of creditworthiness, enabling investors and lenders to make more informed decisions based on finer distinctions in risk levels.
Factors That Influence Credit Ratings:
Credit rating agencies evaluate numerous factors to determine the creditworthiness of a company or government entity. While specific formulas vary among agencies, the following factors generally play a significant role in shaping credit ratings:
Payment History: The entity’s past payment behaviour is a critical factor. Missed payments or previous defaults can negatively impact the credit rating.
Debt Profile: The amount of debt owed and the types of debt instruments held by the entity are considered. Higher debt levels or excessive reliance on certain types of debt may increase risk.
Cash Flows and Income: The current cash flows and income of the entity are analysed to assess its ability to meet financial obligations. Strong and stable cash flows generally contribute to a higher credit rating.
Market and Economic Outlook: The overall market conditions and economic environment are taken into account. Factors such as economic growth, industry trends, and market stability can influence the credit rating.
Unique Factors: Specific circumstances that may affect the entity’s ability to repay debts are evaluated. These factors could include legal or regulatory issues, geopolitical risks, or other exceptional events that could impact financial stability.
It is important to note that credit ratings involve some level of judgment on the part of the rating agency and are subject to change. Even entities with flawless payment history may be downgraded if the agency perceives future challenges that could impair their repayment capacity.
Credit rating agencies consider various factors, such as payment history, debt profile, cash flows, market conditions, and unique circumstances, to evaluate the creditworthiness of entities. These factors collectively determine the assigned credit rating, which helps investors and lenders assess the risk associated with lending or investing in a particular entity.