What is Credit Rating Definition?
Credit ratings are forward opinions on the creditworthiness of a company or government, its reflect the ability and willingness of repaying the debt within the established due dates. The credit ratings are typically based on how much money, property, financial history of borrowing of a debtor.
The credit ratings are evaluated and published by various credit rating agencies (CRA), However, the global credit rating industry is highly concentrated, 85% of the market share controlled by the big three credit rating agencies—Standard & Poor’s, Moody’s, and Fitch which are controlling nearly the entire market.
Credit ratings provide transparent information to the issuers, intermediaries, and investors. Normally, investors use credit rating as one of many inputs for their decision-making processes.
- Debt issuers — utilize for evaluation of their creditworthiness and credit risk.
- Intermediaries — use credit rating to evaluate credit risk to set initial pricing for individual debt issues they structure, determine the interest rate issues will pay, or use to package assets into securities or finance instruments.
- Investors — use credit ratings to make informed decisions, such as supplementing their own credit analysis or establishing thresholds for credit risk and investment guideline.
Normally, a credit rating agencies assign grades of credit ratings by a letter for scale ranging from AAA (the best) to C (the worst) and D (default).
Credit Rating
Credit rating is never a static number, but assigned by a letter. Each credit rating agency uses its own terminology for their credit ratings. However, we are still able to categorize credit ratings into two groups: investment grade and speculative grade.
Investment grade — High creditworthiness grade, however, this paid less interest rate compared with speculative grade.
- AAA — Extremely strong capacity to meet financial commitments.
- AA — Very strong capacity to meet financial commitments.
- A — Strong capacity to meet financial commitments, but somewhat susceptible to economic conditions and changes in circumstances.
- BBB — Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.
Speculative grade — High risk rating, but these offer higher interest rate in exchange.
- BB — Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions.
- B — More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments.
- CCC — Currently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments.
- CC — Highly vulnerable; default has not yet occurred, but is expected to be a virtual certainty.
- C — Currently highly vulnerable to non-payment, and ultimate recovery is expected to be lower than that of higher rated obligations.
- D — Payment default on a financial commitment or breach of an imputed promise; also used when a bankruptcy petition has been filed.
These credit rating in our example from the S&P Global Rating is just an idea to understand how the credit rating works. For the real (and all) credit rating of each credit rating agency please take a look at the rating company’s websites at the references section.
For an investor, a return on investment from debt instruments are in the opposite direction of the credit rating. The higher credit rating gives the lower return, while the lower credit rating gives the higher return (in exchange for the risk of default), however, this is not an assurance or guarantee of financial performance.
References:
- A Credit Rating is an Informed Opinion by S&P Global Ratings
- Rating Scale and Definitions by Moody’s
- Rating Definitions by Fitch Ratings
