Credit Quality: What It Means and How It's Calculated

What Is Credit Quality?

Credit quality is a measurement of an individual or company's creditworthiness, specifically their ability to repay their debts. Credit quality is one of the principal criteria used for judging the investment quality of a bond or a bond mutual fund.

Credit Quality and Individuals

The creditworthiness of an individual can be judged through various means, most commonly (and quickly) through their credit score.

FICO scores are the oldest and most widely used credit scores, although FICO has some newer competitors, such as VantageScore.

Lenders may use an individual's credit score (along with other details in that person's credit reports) as a way of assessing their credit risk and, ultimately, making a decision about whether or not to extend credit to them. Credit scores are also used by insurance companies, employers, landlords, and others.

In essence, a credit score is a mathematical summary of the information in a person's credit reports, typically on a scale ranging from 300 to 850.

Credit scoring formulas assign weights to various aspects of a person's credit history. FICO scores, for example, give the highest weight to payment history (whether the person has consistently paid their credit bills on time), which accounts for 35% of their score. Amounts owed, including their credit utilization ratio) counts for 30%. Length of credit history (older accounts are better) counts for 15%. New accounts (too many of them is a negative) and credit mix (having a variety of credit types, such as a credit card and a mortgage, is a plus) count for 10% each.

In general, the higher a person's credit score, the more creditworthy that person is considered to be and the more likely they are to be approved for a loan or credit card. In addition, having a high credit score tends to help borrowers get more favorable interest rates. Scores above 670 are generally considered good or better.

Any individual may have multiple credit scores. For example, there are different scoring models used for mortgage companies, auto lenders, and credit card issuers.

Credit Quality and Companies or Other Bond Issuers

Credit ratings are to corporations and other bond issuers what credit scores are to individuals, a form of shorthand for describing their credit quality. A credit rating can be assigned to an entire company or to a particular issue of its bonds.

Also referred to as bond ratings, credit ratings are assigned by independent bond rating agencies, such as Fitch Ratings, Moody's Investors Service, and S&P Global. Another major company, AM Best, specializes in ratings of insurance companies. Each rating agency has its own alphabetical designations, although they are relatively similar. Most range from high (AAA to AA), to medium (A to BBB), and low (BB, B, CCC, CC, C, and D). Rating agencies are typically paid by the companies they rate.

In the credit markets, high credit ratings are also referred to as investment-grade ratings. Investment-grade bonds typically have ratings of AAA, AA, A, or BBB.

Non-investment-grade bonds, also referred to as high-yield or junk bonds, are judged to have lower credit quality and, therefore, to present a higher risk to investors. Non-investment-grade bonds typically have ratings of BB and lower. These ratings indicate that there's a greater chance that the bond issuer will be unable to fulfill its obligations, or default. In fact, D, the lowest grade, is reserved for bonds that are already in default.

While investment-grade bonds often pay a lower interest rate, non-investment grade bonds typically offer investors higher rates to compensate for their greater potential risk. There are bond mutual funds and ETFs that specialize in bonds of different grades.

In terms of rating entire companies, corporate credit ratings are based on a firm's financial statements, including its capital structure, credit payment history, revenue, and earnings. Corporate credit ratings are meant to help assess the firm's ability to pay its debts.

Credit rating agencies also assign ratings to insurance companies (to indicate their financial strength and likely ability to pay future claims), governments and government agencies that issue debt, and even entire nations.

The credit rating agencies stress that their ratings are basically well-informed judgment calls. S&P Global, for example, refers to its ratings as "forward-looking opinions about the ability and willingness of debt issuers, like corporations or governments, to meet their financial obligations on time and in full" and as just "one of many inputs" for investors to consider.

The Bottom Line

Credit scores and credit ratings are informed judgments of the credit quality of individuals and other entities, respectively. Both can be useful to lenders, investors, and others, but it's worth remembering that their number or letter grades are simply estimates and shouldn't be considered perfectly predictive.