Corporate Credit Rating: Measured By Credit Rating Scales

A corporate credit rating is a numerical or quantified assessment of a company's creditworthiness, which shows investors the likelihood of a company defaulting on its debt obligations or outstanding bonds.

Corporate credit ratings are issued by rating agencies. A credit rating agency or company helps investors decide how risky it is to invest in a specific country, security, or bond by providing independent, objective assessments of the creditworthiness of companies and countries.

Understanding Corporate Bonds

Companies issue bonds, which are debt securities, to raise funds that can be used to invest in the long-term future of the company. A corporate bond is a debt instrument or IOU from a company that investors can buy and, in doing so, pay the company the value of the bond upfront, which is called the principal amount.

In return, the company pays the investor interest (called a coupon rate) on the bond's principal amount via periodic interest payments. At the bond's maturity date, which is typically in one to five years, the principal is paid back to the investor.

Before investors buy a corporate bond, they need to know how financially stable the company is that's issued the bond. In other words, investors need to know whether the company will be able to meet its financial obligations. If a company didn't pay back its investors the bond's principal amount, the corporation would be considered in default, or nonpayment, of the bond. The risk that a company might not pay back the principal amount of a bond is called default risk.

Credit in the Investment World

As investment opportunities become more global and diverse, it is difficult to decide not only which companies but also which countries are good investment opportunities. There are advantages to investing in foreign markets, but the risks associated with sending money abroad are considerably higher than those associated with investing in your domestic market. It is important to gain insight into different investment environments and to understand the risks and advantages these environments pose. Credit ratings are essential tools for helping investors make more informed investment decisions.

The Raters

Globally, there are only three main ratings agencies that provide credit ratings: Moody's, Standard & Poor's (S&P), and Fitch Ratings. Each of these agencies aims to provide a rating system to help investors determine the risk associated with investing in a specific company, government, agency, investment instrument, or market.

Ratings can be assigned to short-term and long-term debt obligations that are issued by a government or a corporation, including banks and insurance companies.

For a government or company, it is sometimes easier to pay back local-currency obligations than to pay foreign-currency obligations. The ratings, therefore, assess an entity's ability to pay debts in both foreign and local currencies. A lack of foreign reserves, for example, may warrant a lower rating for those obligations a country made in a foreign currency.

Ratings are not equal to or the same as buy, sell, or hold recommendations. Ratings measure an entity's ability and willingness to repay debt.

The Ratings Are In

For long-term issues or instruments, the ratings lie on a spectrum ranging from the highest credit quality on one end to default or "junk" on the other. A triple-A (AAA) is the highest credit quality, and C or D (depending on the agency issuing the rating) is the lowest or junk quality. Within this spectrum, there are different degrees of each rating, which are, depending on the agency, sometimes denoted by a plus or negative sign or a number.

Thus, for Fitch Ratings, a "AAA" rating signifies the highest investment grade and means that there is a very low credit risk. "AA" represents very high credit quality; "A" means high credit quality, and "BBB" is a satisfactory credit quality. These ratings are considered to be investment grade, which means that the security or entity being rated carries a high-enough quality level for most financial institutions to make investments in those securities.

BBB is the lowest rating of investment-grade securities, while ratings below "BBB" are considered speculative or junk. Thus, for Moody's, a Ba would be a speculative or low-grade rating, while for S&P, a "D" denotes default of junk bond status. Some investors and financial firms will not or cannot invest in bonds rated "junk."

The following chart gives an overview of the different rating symbols that Moody's and Standard & Poor's issue:

Sovereign Credit Ratings

As previously mentioned, a rating can refer to an entity's specific financial obligation or its general creditworthiness. A sovereign credit rating provides the latter, as it signifies a country's overall ability to provide a secure investment environment. This rating reflects factors such as a country's economic status, transparency in the capital markets, levels of public and private investment flows, foreign direct investment, foreign currency reserves, political stability, or the ability for a country's economy to remain stable despite political change.

A sovereign credit rating is an indication of the viability of a country's investment markets, and as a result, is typically the first metric that most institutional investors look at before investing internationally. The rating provides investors with the risk level associated with investing in the country. Most countries strive to obtain a sovereign rating, including investment grade, to attract foreign investment.

Controversies

While the rating agencies provide a robust service, the value of such ratings has been widely questioned since the 2008 financial crisis. A key criticism is that the issuers themselves pay the credit rating agencies to rate their securities. This became particularly important as the surging real estate market peaked in 2006-2007, a significant amount of subprime debt was being rated by the agencies. The potential to earn high fees created competition between the three major agencies to issue the highest ratings possible. When the housing market began to collapse in 2007-2008, rating firms were disastrously late in downgrading those top-notch ratings to reflect present-day reality.

To help resolve the potential conflicts of interest of the credit rating agencies, the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act mandated improvements to regulating credit rating agencies. Under the rules, credit rating agencies have to publicly disclose how their ratings have performed. They are also held liable for ratings that they should have known were inaccurate. In 2013, Standard & Poor's, Moody's, and Fitch Ratings were sued for assigning artificially high credit ratings to the mortgage bonds held in a Bear Stearns hedge fund.

Any good investment firm or bank, whether it manages a mutual fund, hedge fund, or offers wealth management services to its clients, will not rely solely on a bond rating from a credit agency to determine if an investment is safe. Typically, the in-house research department will help make the determination, which is why it's important for investors to perform research and due diligence by questioning the initial bond rating and frequently reviewing the ratings for any changes over the life of the investment.

The Bottom Line

A credit rating is a useful tool not only for the investor but also for the entities looking for investors. An investment-grade rating can help a security, company, or country attract both domestic and foreign investments. For emerging market economies, a solid credit rating is critical to demonstrating their creditworthiness to foreign investors. Also, a better rating typically means a lower interest rate, reducing the chances of default in a rising rate environment.