What Is a Corporate Credit Rating and How Does It Work?
When a firm’s creditworthiness is evaluated numerically or quantitatively, investors are informed of the likelihood that the company would default on its debt obligations or outstanding bonds.
Rating agencies are responsible for assigning credit ratings to companies. Investors can determine how hazardous it is to invest in a given country, security, or bond by relying on credit rating agencies or organizations to provide unbiased, impartial assessments of the creditworthiness of corporations and countries. 1
The Most Important Takeaways
- A corporate credit rating is a numerical assessment of a firm’s creditworthiness that determines the possibility of the company failing on its debt obligations.
- Corporate credit ratings are produced by rating organizations and are used to assist investors in determining the level of risk involved with investing in a corporate bond or other corporate debt.
- Corporate credit ratings can range from the highest credit quality on one end of the spectrum to default or “junk” on the other end of the spectrum.
- When it comes to credit quality, a triple-A (AAA) is the highest, and a C or D (depending on which agency issued the rating) is the lowest or junk quality.
Corporate Bonds: What You Need to Know
The purpose of bond issuance, which is a type of debt security, is for companies to raise capital that can be used to invest in the company’s long-term development. It is possible for investors to purchase corporate bonds and, in doing so, pay the company the value of the bond up front (the principle amount), which is referred to as a debt instrument or an IOU from a company.
Periodic interest payments are made to the investor in exchange for which the corporation pays interest (referred to as a coupon rate) on the bond’s principal amount. The principal of the bond is repaid to the investor when the bond reaches its maturity date, which is normally one to five years after it is issued.
Before investing in a corporate bond, investors should research the financial stability of the firm that is issuing the bond in question. To put it another way, investors want to know whether or not the company will be able to satisfy its financial responsibilities in the future. If a corporation fails to repay the principal amount of a bond to its investors, the corporation is deemed to be in default, or nonpayment, of the bond. Default risk refers to the possibility that a corporation will fail to repay the principal amount of a bond when due.
In the Investment World, credit is important.
Due to the fact that investment prospects are becoming more worldwide and diverse, it is becoming increasingly difficult to determine which firms to invest in as well as which countries to invest in. Investment in foreign markets has its advantages, but there are significant risks associated with transferring money abroad that are far greater than the risks associated with investing in your own market. 2 Developing an understanding of distinct investment environments, as well as the dangers and opportunities that these settings present, is critical for successful investing. Investment credit ratings are critical instruments for assisting investors in making better-informed investment decisions.
There are only three major credit rating agencies in the world: Moody’s, Standard & Poor’s (S&P), and Fitch Ratings. Moody’s is the most well-known of the three. Each of these organizations aspires to create a rating system that will assist investors in determining the risk associated with investing in a given firm, government, agency, investment instrument, market, or other investment vehicle.
Ratings can be assigned to both short-term and long-term debt obligations that are issued by the government or a corporation, such as banks and insurance firms, among other entities.
It is sometimes easier for a government or firm to pay back local-currency commitments than it is to pay back foreign-currency liabilities for several reasons. A company’s ability to pay debts in both foreign and local currencies is consequently assessed by its credit ratings. For example, a country’s inability to meet its debts in a foreign currency due to a lack of foreign reserves may be assigned a poorer credit rating.
Ratings are neither the same as, nor are they equivalent to, buy, sell, and hold recommendations. An entity’s ability and willingness to repay debt are measured by its rating.
The Results Have Arrived
Ratings are assigned to long-term issues or instruments based on a scale ranging from the best credit quality on one end to default or “junk” on the other end of the scale. When it comes to credit quality, a triple-A (AAA) is the highest, and a C or D (depending on which agency issued the rating) is the lowest or junk quality. Within this spectrum, there are varying degrees of each grade, which are sometimes marked by a plus or minus sign or a number, depending on the agency in charge of the assessment.
As a result, according to Fitch Ratings, a “AAA” rating is the highest investment grade and indicates that the credit risk is extremely low. “AA” denotes exceptionally good credit quality, “A” denotes outstanding credit quality, and “BBB” denotes credit quality that is satisfactory. All of these ratings are deemed investment grade, which means that the security or entity receiving the rating has an adequate quality level for most financial institutions to consider investing in the security or entity in question.
A rating of BBB is the lowest possible for investment-grade assets, whereas ratings lower than “BBB” are considered speculative or trash. As an example, a Ba rating from Moody’s would indicate a speculative or low-grade rating, but a “D” rating from Standard & Poor’s would indicate default or junk bond status. Some investors and financial institutions will not or are unable to invest in bonds with a “junk” rating.
The following chart provides an overview of the various rating symbols that Moody’s and Standard & Poor’s assign to debt obligations:
Credit Ratings for Governments
As previously stated, a rating can refer to a single financial obligation of a business as well as to the entity’s overall creditworthiness.
The latter is provided by a sovereign credit rating, which indicates a country’s overall ability to provide a secure investment environment in terms of financial stability. It is based on a number of factors, including a country’s economic status, transparency in the capital markets, levels of public and private investment flows (both domestic and foreign), foreign direct investment, foreign currency reserves, political stability, and a country’s ability to maintain economic stability in the face of political change.
An indication of the viability of a country’s investment markets, a sovereign credit rating is often the first statistic that most institutional investors consider before making an overseas investment decision. The rating informs investors about the level of risk associated with making an investment in the country. For the purpose of attracting foreign investment, the majority of governments try to earn a sovereign rating, especially an investment grade rating.
As a result of the global financial crisis of 2008, many people have begun to question the reliability of credit ratings provided by rating organizations. The fact that the issuers themselves pay the credit rating firms to rate their securities is a major source of criticism.
This became particularly critical as the soaring real estate market reached its zenith in 2006-2007, at a time when the rating agencies were rating a considerable amount of subprime debt. Because of the possibility for substantial fees, there was intense competition among the three major rating agencies to provide the highest possible ratings. When the housing market began to tank in 2007-2008, rating agencies were a year or more behind the curve in reducing their top-notch ratings to reflect current market conditions.
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 mandated changes to the way credit rating companies were regulated in order to assist in resolving potential conflicts of interest between them. Credit rating organizations are required to publicly reveal how their ratings have fared in accordance with the rules. They can also be held accountable for ratings that they should have known were erroneous, according to the law. 9 Standard & Poor’s, Moody’s, and Fitch Ratings were sued in 2013 for allegedly assigning fraudulently high credit ratings to mortgage bonds held by a Bear Stearns hedge fund, which was later found to be false.
Whether managing a mutual fund or a hedge fund or providing wealth management services to its clients, any reputable investment business or bank will not rely exclusively on the bond rating of a credit rating agency to judge whether or not an investment is safe. Typically, the in-house research department will contribute to the decision, which is why it is critical for investors to conduct research and due diligence by challenging the original bond rating and regularly evaluating the ratings for any changes over the course of the investment’s life.
What’s the bottom line?
A credit rating is a useful instrument not only for investors, but also for companies who are looking for new sources of financing. A high investment-grade rating can assist a security, company, or country in attracting both local and international capital investment. For emerging market economies, having a strong credit rating is essential for establishing their creditworthiness to foreign investors and other financial institutions. In addition, a higher credit rating often translates into a lower interest rate, which reduces the likelihood of default in a rising interest rate environment.