Credit Rating: What It Is and Why It's Important to Investors (2023)

What Is a Credit Rating?

The term credit rating refers to a quantified assessment of a borrower's creditworthiness in general terms or with respect to a particular debt or financial obligation. A credit rating can be assigned to any entity that seeks to borrow money—an individual, a corporation, a state or provincial authority, or a sovereign government.

Individual credit scores are calculated by credit bureaus such as Experian, Equifax, and TransUnion on a three-digit numerical scale using a form of Fair Isaac Corporation (FICO) credit scoring. Credit ratings for companies and governments are calculated by a credit rating agency such as ,Moody’s, or Fitch Ratings. These rating agencies are paid by the entity seeking a credit rating for itself or one of its debt issues.

Key Takeaways

  • A credit rating is a quantified assessment of the creditworthiness of a borrower in general terms or with respect to a financial obligation.
  • Credit ratings determine whether a borrower is approved for credit as well as the interest rate at which it will be repaid.
  • A credit rating or score is assigned to any entity that wants to borrow money—an individual, a corporation, a state or provincial authority, or a sovereign government.
  • Credit for individual consumers is rated on a numeric scale based on the FICO calculation by credit bureaus.
  • Bonds issued by businesses and governments are rated by credit agencies on a letter-based system ranging from AAA to D.

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Credit Rating

Understanding Credit Ratings

A loan is a debt—essentially a promise, often contractual. A credit rating determines the likelihood that the borrower will be willing and able to pay back a loan within the confines of the agreement without defaulting.

A high credit rating indicates that a borrower is likely to repay the loan in its entirety without any issues, while a poor credit rating suggests that the borrower might struggle to make their payments. Just as an individual credit score is used to evaluate the creditworthiness of a single person, businesses also use credit ratings to demonstrate their creditworthiness to prospective lenders.

(Video) Credit rating for a Company and its Importance for an Investor!

Credit Ratings vs. Credit Scores

Credit ratings apply to businesses and governments as well as individuals. For example, sovereign credit ratingsapply to national governments while corporate credit ratingsapply solely to corporations.Credit scores, on the other hand,apply only to individuals.

Credit scores are derived from the credit history maintained by credit-reporting agencies such as Equifax,Experian, and TransUnion. An individual’s credit score is reported as a number, generally ranging from 300 to 850.

A short-term credit rating reflects the likelihood that a borrower will default within the year. This type of credit rating has become the norm in recent years, whereas in the past, long-term credit ratings were more heavily considered. Long-term credit ratings predict the borrower’s likelihood of defaulting at any given time in the extended future.

Credit rating agencies typically assign letter grades to indicate ratings. S&P Global, for instance, has a credit rating scale ranging from AAA (excellent) to C and D. Adebt instrument with a rating below BB is considered to be a speculative-grade or junk bond, which means it is more likely to default on loans.

A Brief History of Credit Ratings

Moody’s issued publicly available credit ratings for bonds in 1909, and other agencies followed suit in the decades after. These ratings didn’t have a profound effect on the market until 1936 when a new rule was passed that prohibited banks from investing in speculative bonds—that is, bonds with low credit ratings.

The aim was to avoid the risk of default, which could lead to financial losses. This practice was quickly adopted by other companies and financial institutions. Soon enough, relying on credit ratings became the norm.

The global credit rating industry is highly concentrated, with three agencies controlling nearly the entire market: Moody’s, S&P Global, and Fitch Ratings.

Fitch Ratings

John KnowlesFitchfounded the Fitch Publishing Company in 1913, providing financial statistics for use in the investment industry via "The Fitch Stock and Bond Manual" and "The Fitch Bond Book." In 1924, Fitch developed and introduced the AAA through D rating system that has become the basis for ratings throughout the industry.

In the late 1990s, with plans to become a full-service global rating agency, Fitch Ratings merged with IBCA of London,a subsidiaryof Fimalac, S.A., a Frenchholding company. Fitch also acquired market competitors Thomson BankWatch and Duff & Phelps Credit Rating Co.

Beginning in 2004, Fitch started to develop operating subsidiaries specializing in enterpriserisk management, data services, andfinance-industry training with the acquisition of a Canadian company, Algorithmics, and the creation of Fitch Solutions and Fitch Learning.

Moody’s Investors Service

John Moody and Company first publishedMoody’s Manual of Industrial and Miscellaneous Securities in 1900. The manual published basic statistics and general information about stocks and bonds of various industries.

From 1903 until thestock marketcrash of 1907, Moody’s Manual was a national publication. In 1909, Moody began publishing Moody’s Analyses of Railroad Investments, which added analytical information about thevalueof securities.

(Video) Credit Rating: What It Is and Why It's Important to Investors

Expanding this idea led to the 1914 creation ofMoody’s Investors Service, which in the following 10 years would provide ratings for nearly all of the governmentbond marketsat the time. By the 1970s, Moody’s began ratingcommercial paperandbank deposits, becoming the full-scale rating agency that it is today.

S&P Global

In 1860, Henry Varnum Poor first published the History of Railroads and Canals in the United States, the forerunner of securities analysis and reporting that developed over the next century. The Standard Statistics Bureau, formed in 1906, publishedcorporate bond,sovereign debt, andmunicipal bondratings. Standard Statistics merged with Poor’s Publishing in 1941 to formStandard & Poor’s Corporation.

Standard & Poor’s Corporation was acquired by the McGraw-Hill Companies in 1966, and in 2016, the company rebranded as S&P Global. It has become best known for indexes such as theS&P 500, introduced in 1957, a stockmarket indexthat is both a tool for investor analysis and decision-making and a U.S.economic indicator.

Importance of Credit Ratings

Credit ratings for borrowers are based on substantialdue diligenceconducted by the rating agencies. Though a borrowing entity will strive to have the highest possible credit rating because it has a major impact on interest rates charged by lenders, the rating agencies must take a balanced and objective view of the borrower’s financial situation and capacity to service and repay the debt.

A credit rating determines not only whether or not a borrower will be approved for a loan but also the interest rate at which the loan will need to be repaid. As companies depend on loans for many startup and other expenses, being denied a loan could spell disaster, and a high-interest-rate loan is much more difficult to pay back. A borrower's credit rating should play a role in determining which lenders to apply to for a loan. The right lender for someone with great credit likely will be different than for someone with good or even poor credit.

Credit ratings also play a large role in a potential investor’s decision as to whether or not to purchase bonds. A poor credit rating is a risky investment. That's because it indicates a larger probability that the company will be unable to make its bond payments.

Credit ratings are never static, which means borrowers must remain diligent in maintaining a high credit rating. They change all the time based on the newest data, and one negative debt will bring down even the best score.

Credit also takes time to build up. An entity with good credit but a short credit historyis notviewed as positively as another entitywith equally good credit buta longer credit history. Debtors want to know if a borrower can maintain good credit consistently over time.

Considering how important it is to maintain a good credit rating, it's worth looking into thebest credit monitoring servicesand perhaps choosing one as a means of ensuring your information remains safe.

AA+

The credit rating of the U.S. government by Standard & Poor’s, reduced the country’srating fromAAA(outstanding) to AA+ (excellent) on Aug. 5, 2011. Global equity markets plunged for weeks following the downgrade.

(Video) Credit Ratings

Credit Ratings Scale

While each rating agency uses a slightly different scale, they each assign ratings as a letter grade for long-term debts. A rating of AAA is the highest possible credit rating, while a rating in the D's or C's is the lowest.

The rating scales for long-term debt at the three leading agencies are illustrated below:

Credit Ratings Scale: Highest to Lowest
Standard & PoorsMoody'sFitchRatings
AAAAaaAAA
AAAaAA
AAA
BBBBaaBBB
BBBaBB
BBB
CCCCaaCCC
CCCaCC
CCC
DRD
D

Note that there are 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 issuance is slightly more creditworthy than a Baa3 issuance, and slightly less so than one rated Baa1.

Investment Grade vs. Speculative Ratings

The range of possible credit ratings is divided into two categories: investment and non-investment-grade debt.

Investment-Grade Ratings

Government or corporate borrowers with a rating between BBB and AAA are considered to have investment-grade credit. These are extremely low-risk borrowers, who are considered very likely to meet all of their payment obligations. Because there is high demand for their debt, these companies or governments can usually borrow money at extremely low interest rates.

Non-Investment Ratings

A credit rating of BB or lower indicates non-investment or speculative-grade debt. The derisive term "junk bonds" is also used for these borrowers, indicating the perceived likelihood that they are at risk of default, or have already done so. However, there is one advantage to these types of bonds: they typically pay out higher interest to the bondholder.

Factors That Affect Credit Ratings

Credit agencies consider several factors when rating a potential borrower. First, an agency considers the entity’s past history of borrowing and paying off debts. A history of missed payments, defaults, or bankruptcies can negatively impact the rating.

The agency also looks at the borrower's cash flows and current debt levels. If the organization has steady income and the future looks bright, the credit rating will be higher. If there are any doubts about the borrower's economic outlook, their credit rating will fall.

These are some of the factors that can influence the credit rating of a company or government borrower:

  • The organization's payment history, including any missed payments or defaults.
  • The amount they currently owe, and the types of debt they have.
  • Current cash flows and income.
  • The market outlook for the company or organization.
  • Any organizational issues that might prevent timely repayment of debts.

Note that credit ratings involve some subjective judgments, and even an organization with a spotless payment history can be downgraded if the rating agency believes that its ability to make repayments has changed.

For example, in 2011, Standard and Poor's reduced the credit rating of United States sovereign bonds from AAA to AA+, in response to Congressional roadblocks that could have caused a default. Even though the government ultimately made all of its payments on time, even the mere discussion of nonpayment was enough to cause a more negative outlook on U.S. government debt.

(Video) Why Are Credit Ratings Useful?

Frequently Asked Questions

What's the Difference Between Credit Ratings and Credit Scores?

Credit ratings apply to businesses and governments. For example, sovereign credit ratings apply to national governments while corporate credit ratings apply solely to corporations. Credit rating agencies typically assign letter grades to indicate ratings. S&P Global, for instance, has a credit rating scale ranging from AAA (excellent) to C and D. Credit scores, on the other hand, apply only to individuals and are reported as a number, generally ranging from 300 to 850.

Why Are Credit Ratings Important?

Credit ratings or credit scores are based on substantial due diligence conducted by the rating agencies who must take a balanced and objective view of the borrower’s financial situation and capacity to service/repay the debt. This can impact whether or not a borrower will be approved for a loan but also the interest rate at which the loan will need to be repaid.

Credit ratings also play a large role in a potential investor’s decision as to whether or not to purchase bonds. A poor credit rating makes for a riskier investment because the probability of the company defaulting on bond payments is viewed to be higher.

What Does a Credit Rating Tell an Investor?

A short-term credit rating reflects the likelihood that a borrower will default within the year. This type of credit rating has become the norm in recent years, whereas in the past, long-term credit ratings were more heavily considered. Long-term credit ratings predict the borrower’s likelihood of defaulting at any given time in the extended future. A debt instrument with a rating below BB is considered to be a speculative-grade or junk bond, which means it is more likely to default on loans.

What Factors Affect an Individual's FICO Score?

An individual's FICO score is comprised of five factors along with the respective weights attached to each. These factors are payment history (35%), amounts owed (30%), length of credit history (15%), new credit (10%), and types of credit (10%). It is important to note that FICO scores do not take age into consideration but they do weigh the length of one's credit history.

The Bottom Line

Credit ratings are the corporate equivalent of a personal credit score. Instead of the 300-850 scale of an individual FICO score, debts by business or government borrowers are rated on a scale of D to AAA. These credit ratings indicate the likelihood that a borrower can make punctual repayments. A low credit rating can lead to higher interest rates on a borrower's loans and ultimately lead to greater financial issues down the road.

FAQs

How does credit rating help investors? ›

Both institutional and individual investors use credit ratings to assess the risk related to investing in a specific issuance, ideally in the context of their entire portfolio. Intermediaries such as investment bankers utilize credit ratings to evaluate credit risk and further derive pricing of debt issues.

What is a credit rating and why is it important? ›

A credit rating is a quantified assessment of the creditworthiness of a borrower in general terms or with respect to a financial obligation. Credit ratings determine whether a borrower is approved for credit as well as the interest rate at which it will be repaid.

How credit rating is significant to the investors and issuers both? ›

Since it is used by lenders and investors to decide whether or not to approve loans or join in business ventures, it is important to have a good credit rating as it can help a company raise money, reduce interest rates, and also encourages better accounting standards.

Which credit rating is most important? ›

FICO® Scores are used by 90% of top lenders, but even so, there's no single credit score or scoring system that's most important. In a very real way, the score that matters most is the one used by the lender willing to offer you the best lending terms.

Why is rating so important? ›

Rating and reviews are the number one online feature shoppers rely on when making informed product decisions faster, more so than product page descriptions, chat bots, and the website's search tool. But consumers aren't just using them online.

Why do bond investors care about credit ratings? ›

Ratings allow investors to understand how likely a bond is to default, to or fail to make its interest and principal payments on time. Learn what the ratings mean to the agencies and what they might mean to investors.

What is a good credit rating? ›

Although ranges vary depending on the credit scoring model, generally credit scores from 580 to 669 are considered fair; 670 to 739 are considered good; 740 to 799 are considered very good; and 800 and up are considered excellent.

Why are ratings important to business? ›

Online reviews are important because they help showcase your company's reputation, they increase sales and improve search rankings for your website. And get this—did you know that reviews influence 90% of potential customers better than a sales pitch?

What is the full meaning of rating? ›

A rating of something is a score or measurement of how good or popular it is. ... a value-for-money rating of ten out of ten. The president's approval rating at its lowest point since he took office. Synonyms: position, ranking, evaluation, classification More Synonyms of rating.

What are the 2 most important things on a credit report? ›

Of these factors, payment history and credit utilization are the most important information. Together, they make up more than 60% of the impact on your credit scores.

What are the two most important factors of your credit score? ›

The most important factor of your FICO® Score , used by 90% of top lenders, is your payment history, or how you've managed your credit accounts. Close behind is the amounts owed—and more specifically how much of your available credit you're using—on your credit accounts.

What 3 things are used to determine your credit rating? ›

How far behind you are on a bill payment, the number of accounts that show late payments and whether you've brought the accounts current are all factors. The higher your number of on-time payments, the higher your score will be. Every time you miss a payment, you negatively impact your score.

How does credit rating affect interest rates? ›

A higher score increases a lender's confidence that you will make payments on time and may help you qualify for lower mortgage interest rates and fees.

What is a credit rating simple? ›

Answer # 0285. Credit ratings are codes that lenders use to rate how and when you make payments. Credit ratings are contained in credit reports. A credit reports is a file kept by credit reporting agencies that contains information on a person's credit history.

What is a credit rating for dummies? ›

A credit score is a prediction of your credit behavior, such as how likely you are to pay a loan back on time, based on information from your credit reports.

What credit rating tells us? ›

A credit Score is a number used by lenders as an indicator of how likely an individual is to repay his debts and the probability of going into default. It is an independent assessment of the individual's risk as a credit applicant.

What are two other reasons why a good credit rating is important? ›

“A high credit score means that you will most likely qualify for the lowest interest rates and fees for new loans and lines of credit,” McClary says. And if you're applying for a mortgage, you could save upwards of 1% in interest.

What affects a person's credit rating? ›

The primary factors that affect your credit score include payment history, the amount of debt you owe, how long you've been using credit, new or recent credit, and types of credit used. Each factor is weighted differently in your score.

What are examples of credit ratings? ›

Typically, ratings are expressed as letter grades that range, for example, from 'AAA' to 'D' to communicate the agency's opinion of relative level of credit risk.

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