Credit ratings are a key component in evaluating the security of a bond, as well as bond mutual funds and ETFs. Therefore, investors need to understand what credit ratings mean, how to use these ratings to assess risk, and what role the credit rating agencies play in the process.
Credit Rating Definition
A credit rating is a letter-based score that reflects the credit worthiness of an entity, such as a government, municipality or corporation, that issues debt. To arrive at a credit rating, credit agencies review and assess the entity's financial strength and ability to honor its loan obligations by making interest payments and to paying the loan balance in full at maturity.
Note: Investors may use credit ratings to assess the credit quality of a bond before considering a purchase or sale of the bond. Investors may also review the average credit quality of the bonds held in a mutual fund or of a bond index whose performance is tracked by an ETF.
Credit Rating vs. Credit Score
Credit ratings are similar to credit scores in that they both measure and score the creditworthiness of a borrower with respect to a debt obligation. Where these terms differ is that credit ratings are letter-based grades given to a borrowing entity, such as a corporation or a government, whereas a credit score is a numerical grade given to an individual.
Another similarity between credit ratings and credit scores is that a higher rating or score generally qualifies the borrower for more favorable borrowing terms, including lower interest rates and larger loans, compared to borrowers with lower ratings or scores.
While a corporation may borrow money by issuing bonds for the purpose of financing a project, or to purchase an asset like a building, an individual may obtain a loan to finance the purchase of a home or vehicle. In both cases, a higher credit rating or score can help the corporation or individual, respectively, not only to qualify for the debt but also to qualify for better (lower) interest rates.
How Credit Ratings Work
Credit ratings for bond issuing entities are assigned by credit ratings agencies, who research the financial health of the respective entities and assess their ability to meet debt obligations. The credit rating, which is a letter-based score, is a determining factor in the interest rate paid on the bond. Bond issuing entities may include corporations, governments, or municipalities, who borrow money by issuing bonds to finance their operations.
The basics in how credit ratings work are:
- Credit rating agencies research and evaluate the financial strength of the borrower, in this case an entity that may issue a bond.
- Rating agencies use multiple metrics to determine the rating, including the entity's financial statements, competition, financial outlook, and macroeconomic factors.
- A letter-based grade is assigned to the issuing entity that reflects its financial ability to meet its debt obligations, which is to make interest payments and to pay off the loan in full at maturity.
- The credit rating is a determining factor of the interest rate and other terms. Those with poorer credit ratings may have to issue debt on less favourable terms.
Credit Ratings Scale Chart By Agency
|A+||A1||A+||Upper Medium Grade|
|A||A2||A||Upper Medium Grade|
|A-||A3||A-||Upper Medium Grade|
|BBB+||Baa1||BBB+||Lower Medium Grade|
|BBB||Baa2||BBB||Lower Medium Grade|
|BBB-||Baa3||BBB-||Lower Medium Grade|
Note: "Junk" status begins with non-investment grade and includes credit qualities worse (lower) than that on the credit rating scale. Also known as high-yield bonds, junk bonds pay higher yields than investment grade bonds because of the higher degree of default risk. The US government began using junk bonds in the 1780s because its government was still unproven. In the early 1900s, junk bonds were used as a form of financing startups. The junk bond market experienced a boom in the 1970s and 1980s, due to so-called "fallen angels," which are companies that had previously been investment grade status.
Credit Rating Agencies
Just as there are three main credit bureaus that evaluate and score the creditworthiness of individuals, there are three main credit rating agencies that evaluate and rate entities to assess their ability to meet debt obligations. The three bond credit rating agencies, also known as "The Big Three" are
- Standard & Poor's,
- Moody's, and
- Fitch Ratings.
Investors who want to find credit ratings for bond issuing companies or governments can find them directly on the credit agency websites.
1. Standard & Poor's
S&P Global Inc (SPGI), also known as Standard & Poor's, headquartered in New York, NY, is the parent company of S&P Global Ratings, which is considered the largest of the big three ratings agencies. The S&P ratings scale consists of 11 total grades ranging from the highest grade of AAA, down to the lowest grade of D.
Moody's Corporation (MCO), which is often referred to as Moody's, is an American financial services company based in New York, NY. Moody's is the parent company of Moody's Investor Services, which is its holding company responsible for credit ratings. The Moody's rating scale has a total of 21 notches, which range from a high of Aaa to a low of C.
3. Fitch Ratings
Headquartered in New York, NY, Fitch Ratings is the lesser known of the big three U.S. credit rating agencies but is credited with the creation of the AAA through D rating system used by other rating agencies. The Fitch ratings scale consists of 11 total grades ranging from the highest grade of AAA, down to the lowest grade of D.
Note: Other countries may have their own credit rating agencies, such as Dominion Bond Rating Service in Canada.
Role Of Credit Agencies
The primary role of credit agencies is to research and evaluate the financial health of bond issuers. Thus, the bond market is given a guide for assessing the credit quality and risk of entities issuing bonds. In the marketplace, ratings agencies help determine the cost of borrowing because the ratings they provide determine the interest rates corporations and governments must pay to bond holders. This relates to the financial risk/reward curve - an investor considering bonds from 2 issuers with different credit ratings would typically demand a higher rate of return from the entity with the lower credit rating.
In addition to a credit rating, agencies provide ratings outlooks, which is an evaluation of where a rating is expected to move over time.
Ratings from credit agencies also enable governments of developing countries and emerging markets to issue bonds to institutional investors around the globe.
Note: Credit ratings apply only to debt securities like bonds and can also be assigned to companies and governments. However, credit ratings do not apply to equity securities like common stock.
Credit Rating & Credit Agency History
The history of credit rating agencies began in the early 1900s, with the early formation of today's "Big Three" agencies, Standard & Poor's, Moody's and Fitch Ratings. Fitch was the first to create a rating system of grading debt issuing entities, although Fitch is smaller compared to Moody's and Standard & Poor's, who have expanded to offer multiple financial and research services.
In recent history, specifically in the years leading up to the subprime mortgage crisis of 2007-2008, the Big Three credit rating agencies are notoriously known for their failure to sufficiently warn investors of credit risk in the bond market. As they fought for market share, the credit rating agencies were giving overly-optimistic credit ratings to securities, particularly mortgage-backed assets, that were riskier than the ratings led investors to believe.
This credit crisis, caused in part by the failures of the Big Three credit agencies, would lead to the collapse of three major investment banks, which were Lehman Brothers, Bear Sterns, and Merrill Lynch, and ultimately to The Great Recession of 2008-2009.
Credit Risk & Credit Ratings
Credit risk and credit ratings have an inverse relationship in that the higher the relative default risk of the issuing entity, the lower the credit rating. Thus, the highest credit ratings are rewarded to the issuing entities with the lowest risk of default.
For example, US Treasury bonds currently hold the highest rating of AAA by Standard & Poor's because the United States has very little risk of credit default amongst the entities that issue bonds.
Importance Of Credit Ratings For Investors
Since credit agencies evaluate and rate the creditworthiness of issuing entities, and thus the credit quality of bonds, fixed income investors have available a means of making informed decisions before considering the purchase or sale of bonds in their portfolio.
Because the financial health of a company's financial health can change over time, the credit ratings agencies can downgrade or upgrade a company's rating. A change in a company's rating can change the market price of a bond. Thus, it's important for investors to regularly monitor a bond's rating.
Other than the financial crisis of 2008, there have been more recent periods where credit ratings have impacted not only bond prices but overall market sentiment. For example, credit downgrades, as reported by BlackRock, that have negatively impacted bond and stock market conditions include the U.S. credit downgrades in 2011 and 2023 and corporate bond downgrades at the onset of coronavirus shutdowns in March 2020.
Note: Investors should remember that credit ratings can change and are not predictions about the future price movement of a particular bond. Furthermore, reviewing a company's credit rating should just be one factor among many in the investment selection process.
Credit rating agencies evaluate the creditworthiness of entities that issue bonds and provide a letter-based rating that reflects the credit quality of these debt obligations. For investors, credit ratings can provide a means of assessing a bond's riskiness and for making informed decisions about potentially buying or selling a particular bond.
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