What Is a Credit Rating?

What Is a Credit Rating?

Let me explain what a credit rating really is—it's an independent assessment of how likely a corporation or government is to repay its debts, whether in general or for a specific obligation.

Essentially, a credit rating shows the chance that an issuer might default on a loan or debt due to something like bankruptcy. As an investor, you use these ratings to figure out the risk when buying bonds or other debt from these entities.

There are several independent companies that handle this, such as S&P Global, Moody's, and Fitch Ratings, which assign ratings to companies and governments.

On the other hand, credit scores are for individuals, based on their personal debt history. Lenders check these when deciding to lend money to consumers.

Key Takeaways

Here's what you need to remember: a credit rating evaluates a corporation or government's ability to pay back interest on loans or debt instruments to investors.

These ratings come as letter grades, from AAA at the top to C or D at the bottom.

The big three agencies are Fitch Ratings, Moody's Investors Service, and S&P Global Ratings.

Understanding Credit Ratings

Credit ratings estimate the risk level when lending to a business, government, or agency. A high rating means the agency thinks the issuer will repay without issues; a low one suggests struggles ahead, and the lowest indicate serious financial trouble.

Bonds get rated before issuance, and that rating sets the interest rate—lower-rated issuers pay more to offset the risk.

You, as an investor or lender, rely on these to decide on deals and what interest compensates for the risk.

Agencies assign letter grades; for example, S&P Global goes from AAA (excellent) to C and D. Moody's is similar, from Aaa to C.

Ratings also vary by time: short-term ones look at default risk within a year, which is more common now, while long-term ones predict over extended periods.

A Brief History of Credit Ratings

Credit ratings started in the early 20th century and gained influence after 1936, when regulators banned banks from investing in low-rated speculative bonds to prevent defaults and failures.

This practice spread quickly to other institutions, making credit ratings standard.

The Major Credit Rating Agencies

The industry is dominated by three: Moody’s, S&P Global, and Fitch Ratings, all NRSROs regulated by the SEC.

Fitch Ratings began in 1913 with financial stats, introducing AAA to D in 1924; now it has over 1,550 analysts worldwide.

Moody’s started in 1900 with manuals, rating railroads in 1909 and expanding later; today it's global with over 40 offices.

S&P Global traces to 1860 with railroad data, issuing ratings from 1916; it merged and rebranded, now with 70+ offices in 35 countries.

Importance of Credit Ratings

These ratings matter to investors and the rated entities alike. A high rating lets a company or government borrow affordably; a low one means higher costs or no access.

Entities usually request and pay for their own ratings or those on their securities.

Credit Ratings Scale

Each agency has a slight variation, but ratings are letter grades from AAA (highest) to C or D (lowest).

For long-term debt, S&P and Fitch go AAA to D, Moody's Aaa to C, with sub-divisions like +/− or numbers 1-3.

Ratings split into investment grade (BBB/Baa3 and up) and speculative (below).

Factors That Go Into Credit Ratings

Agencies consider payment history, current debt, cash flows, economic outlook, and unique risks—each with their own formula.

These involve judgment and can change; even perfect histories can get downgraded if future repayment seems impaired.

What's the Difference Between a Credit Rating and a Credit Score?

They're similar but distinct: ratings are for companies or governments, scores for individuals, both indicating repayment risk to lenders.

What Does a Credit Rating Tell an Investor?

It gives an opinion on the entity's financial health and default likelihood, helping you decide on bonds and if the compensation matches the risk.

What Is a Nationally Recognized Statistical Rating Organization?

NRSROs are SEC-overseen agencies like the big three, created post-2008 crisis via Dodd-Frank for better regulation and transparency; there are 10 total.

The Bottom Line

Credit ratings are like corporate credit scores, offering informed risk judgments to investors and lenders, but remember, they're opinions, not guarantees.