What Is a Rating?
Let me explain to you what a rating really is—it's an assessment tool that an analyst or a rating agency assigns to a stock or bond. This rating directly indicates the level of investment opportunity that the stock or bond presents. You should know that the three major rating agencies handling this are Standard & Poor's, Moody's Investors Service, and Fitch Ratings.
Key Takeaways
To break it down simply, a rating is that assessment tool from an analyst or agency for stocks or bonds. Remember, the big three bond rating agencies are Standard & Poor's, Moody's Investors Service, and Fitch Ratings. For bonds, these ratings evaluate the creditworthiness of the issuer or insurer, which you can see as a direct measure of default chances. On the stock side, buy-side and sell-side analysts research and provide opinions, including ratings like 'buy,' 'hold,' or 'sell' for the stocks they cover.
How a Rating Works
Analysts on both the buy-side and sell-side research stocks and write opinions that often include a rating such as 'buy,' 'hold,' or 'sell.' For bonds, the process falls to those three major rating agencies. Keep in mind that a company can boost its rating by keeping debt low and staying alert to any sudden internal changes.
Types of Ratings
Let's dive into the types, starting with analyst ratings. Buy-side analysts write opinions to guide their teams' portfolio decisions, while sell-side analysts aim to educate and promote stocks for clients. For stocks, they might assign 'buy,' 'hold,' or 'sell' with an explanation. Major institutions vary their terms—Morgan Stanley uses 'overweight,' 'equal-weight,' and 'underweight' over 12 to 18 months, while Credit Suisse goes with 'outperform,' 'neutral,' and 'underperform' for 12 months. These are all just variations on the basic buy-hold-sell idea.
A Notable Example
In August 2023, Fitch Ratings downgraded the U.S. credit rating from AAA to AA+, pointing to deteriorating governance in Congress over debt ceiling issues. This brinkmanship raised default risks for international lenders, though the other two agencies held steady.
Rating Agency Ratings
For bonds, agencies assess safety based on the issuer's financial fundamentals, focusing on their ability to repay principal and interest. Moody's and S&P investment-grade ratings from highest to lowest are Aaa/AAA, Aa1/AA+, Aa2/AA, Aa3/AA-, A1/A+, A2/A, A3/A-, Baa1/BBB+, Baa2/BBB, and Baa3/BBB-. Standard & Poor's also provides the S&P 500 Index as a key market gauge. Moody's offers research on bonds with a scale from Aaa (highest) to C (lowest). Fitch considers factors like sensitivity to changes and debt types, helping investors avoid defaults for solid returns. These ratings primarily reflect creditworthiness, serving as a measure of default probability, with stability and payment priority also factored in.
What Does 'Investment-Grade' Mean in Bond Ratings?
A bond qualifies as investment-grade if it's rated BBB- or higher by Standard & Poor's or Baa3 or higher by Moody's. This means the borrower has a strong chance of timely repayment with low risk to you as a lender.
What Does 'Speculative' Mean in Bond Ratings?
If a bond is rated BB+ or lower by Standard & Poor's or Ba1 or lower by Moody's, it's speculative, indicating higher credit risk where borrowers pay elevated interest rates to offset that risk.
What Happens When a Credit Rating Drops?
A rating drop signals that agencies view the borrower as riskier due to more debt, declining income, or other issues affecting repayment. As a result, these borrowers face higher interest rates to attract lenders despite the added risk.
The Bottom Line
Ratings help you assess the quality of investments like stocks or bonds. Analysts and agencies evaluate risks and opportunities using their own systems, so understanding these can guide your decisions effectively.
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