Definition
A credit rating is an independent opinion—expressed as a letter grade—about a corporation’s, government’s, or specific bond’s ability to meet its debt obligations. In plain terms, it signals how likely the issuer is to default (fail to make required payments).
Key points (quick)
– Credit ratings rank default risk for issuers or individual bonds.
– Higher ratings mean lower perceived default risk and typically lower borrowing costs.
– Major global agencies that publish ratings include S&P Global, Moody’s, and Fitch.
– Credit ratings differ from credit scores: ratings apply to issuers or securities; scores apply to individual consumers.
– Short-term ratings cover default risk within about one year; long-term ratings look further into the future.
How ratings are used
– Investors use ratings as a shorthand measure of credit risk when deciding whether to buy bonds or other debt.
– Regulators and many institutional rules reference ratings for permissible investments.
– Issuers usually request ratings and pay the rating agency for the review.
Major agencies and a short history
– Fitch, Moody’s, and Standard & Poor’s (now S&P Global) are the three largest, with roots in publications from the late 19th and early 20th centuries. Their ratings became especially influential after regulations in the 1930s restricted banks from holding low-rated securities.
– In the U.S., these firms are recognized as Nationally Recognized Statistical Rating Organizations (NRSROs) and operate under Securities and Exchange Commission oversight.
Rating scales (how to read them)
– Agencies use letter grades. A typical long-term scale runs from highest creditworthiness to lowest:
– S&P / Fitch: AAA → AA → A → BBB → BB → B → CCC → CC → C → D (with + / − modifiers between many categories).
– Moody’s: Aaa → Aa → A → Baa → Ba → B → Caa → Ca → C (with numeric modifiers inside many categories).
– Grades in the “investment-grade” range (e.g., S&P: BBB− and above) indicate relatively lower default risk; grades below that are considered “speculative” or “high-yield.”
What goes into a credit rating
Analysts combine many factors, such as:
– Financial metrics (debt levels, cash flow, profitability).
– Business model strength and market position.
– Government support or guarantees (for sovereigns and public entities).
– Legal structures and contractual protections for bondholders.
– Economic and industry outlooks.
Ratings reflect both current condition and forward-looking judgment.
Short-term vs long-term ratings
– Short-term ratings focus on the likelihood of default within about 12 months.
– Long-term ratings evaluate default risk over an extended horizon. Both can influence pricing and investor demand.
Credit rating vs credit score
– Credit rating: applies to corporate or sovereign issuers and specific bonds.
– Credit score: numeric measure (e.g., FICO) of an individual consumer’s credit history and likelihood to repay personal loans.
What a rating tells an investor
– Relative default risk compared with other issuers.
– A starting point for pricing expected return: lower-rated bonds usually must offer higher yields to attract buyers.
– Not a guarantee; ratings are opinions based on available information and can change.
Checklist: How to use credit ratings when evaluating a bond
1. Check the issuer’s long-term and short-term ratings.
2. Confirm whether the bond’s rating differs from the issuer (ratings can be assigned to specific issues).
3. Note the rating agency and whether the rating is current.
4. Look for outlook or watch status (e.g., “stable,” “negative,” “positive”).
5. Compare the bond’s yield to similarly rated peers.
6. Review underlying fundamentals (financial statements, sector risks) rather than relying only on the letter grade.
7. Consider how a downgrade could affect price/liquidity and whether you can tolerate that risk.
Worked numeric example (illustrative)
Situation: Two corporate bonds, both with $1,000 face value, pay annual fixed coupons. Bond A is rated AAA and offers a 3.0% coupon. Bond B is rated BB and offers a 7.0% coupon.
– Annual coupon payment on A = $1,000 × 3.0% = $30.
– Annual coupon payment on B = $1,000 × 7.0% = $70.
– Extra annual interest paid to attract investors for lower-rated B = $70 − $30 = $40.
Issuer cost example at scale:
– If a company issues $100 million in debt, the same 4.0 percentage-point spread means an extra $100,000,000 × 4.0% = $4,000,000 per year in interest costs for the lower-rated debt.
This simple calculation shows how rating differences translate directly into financing costs. (Assumes equal maturity and comparable other terms.)
What a rating does not do
– It does not predict exact prices or short-term market moves.
– It is not a guarantee that default cannot occur.
– It is an analyst’s opinion based on available facts and assumptions; agencies can revise ratings.
What an NRSRO is
– Nationally Recognized Statistical Rating Organizations (NRSROs) are firms the U.S. SEC recognizes for statistical credit ratings. The designation affects regulatory and market use of ratings in the United States.
Bottom line
Credit ratings offer a standardized, independent opinion about the creditworthiness of issuers or specific securities. They are a useful starting point for assessing default risk and comparing bonds, but they should be combined with direct analysis of financials, market conditions, and personal risk tolerance.
Sources
– Investopedia — Credit Rating overview: https://www.investopedia.com/terms/c/creditrating.asp
– S&P Global Ratings — About: https://www.spglobal.com/ratings/en/
– Moody’s Investors Service — Ratings & Research: https://www.moodys.com/
– Fitch Ratings — About Fitch Ratings: https://www.fitchratings.com/
– U.S. Securities and Exchange Commission — NRSROs: https://www.sec.gov/spotlight/investor-advisories/nrsro.shtml
Educational disclaimer
This explainer is for educational purposes only. It does not constitute investment advice, an offer to buy or sell securities, or a recommendation for any particular strategy. Always conduct your own research or consult a qualified professional before making investment decisions.