Credit Rating: What It Is and Why It's Important to Investors

What Is a Credit Rating?

The term credit rating refers to a quantified assessment of a borrower's creditworthiness in general terms or with respect to a particular debt or financial obligation. A credit rating can be assigned to any entity that seeks to borrow money—an individual, a corporation, a state or provincial authority, or a sovereign government.

Individual credit scores are calculated by credit bureaus such as Experian, Equifax, and TransUnion on a three-digit numerical scale using a form of Fair Isaac Corporation (FICO) credit scoring. Credit ratings for companies and governments are calculated by a credit rating agency such as S&P Global, Moody’s, or Fitch Ratings. These rating agencies are paid by the entity seeking a credit rating for itself or one of its debt issues.

Understanding Credit Ratings

A loan is a debt—essentially a promise, often contractual. A credit rating determines the likelihood that the borrower will be willing and able to pay back a loan within the confines of the agreement without defaulting.

A high credit rating indicates that a borrower is likely to repay the loan in its entirety without any issues, while a poor credit rating suggests that the borrower might struggle to make their payments. Just as an individual credit score is used to evaluate the creditworthiness of a single person, businesses also use credit ratings to demonstrate their creditworthiness to prospective lenders.

Credit Ratings vs. Credit Scores

Credit ratings apply to businesses and governments as well as individuals. For example, sovereign credit ratings apply to national governments while corporate credit ratings apply solely to corporations. Credit scores, on the other hand, apply only to individuals.

Credit scores are derived from the credit history maintained by credit-reporting agencies such as Equifax, Experian, and TransUnion. An individual’s credit score is reported as a number, generally ranging from 300 to 850.

A short-term credit rating reflects the likelihood that a borrower will default within the year. This type of credit rating has become the norm in recent years, whereas in the past, long-term credit ratings were more heavily considered. Long-term credit ratings predict the borrower’s likelihood of defaulting at any given time in the extended future.

Credit rating agencies typically assign letter grades to indicate ratings. S&P Global, for instance, has a credit rating scale ranging from AAA (excellent) to C and D. A debt instrument with a rating below BB is considered to be a speculative-grade or junk bond, which means it is more likely to default on loans.

A Brief History of Credit Ratings

Moody’s issued publicly available credit ratings for bonds in 1909, and other agencies followed suit in the decades after. These ratings didn’t have a profound effect on the market until 1936 when a new rule was passed that prohibited banks from investing in speculative bonds—that is, bonds with low credit ratings.

The aim was to avoid the risk of default, which could lead to financial losses. This practice was quickly adopted by other companies and financial institutions. Soon enough, relying on credit ratings became the norm.

The global credit rating industry is highly concentrated, with three agencies controlling nearly the entire market: Moody’s, S&P Global, and Fitch Ratings.

Fitch Ratings

John Knowles Fitch founded the Fitch Publishing Company in 1913, providing financial statistics for use in the investment industry via "The Fitch Stock and Bond Manual" and "The Fitch Bond Book." In 1924, Fitch developed and introduced the AAA through D rating system that has become the basis for ratings throughout the industry.

In the late 1990s, with plans to become a full-service global rating agency, Fitch Ratings merged with IBCA of London, a subsidiary of Fimalac, S.A., a French holding company. Fitch also acquired market competitors Thomson BankWatch and Duff & Phelps Credit Rating Co.

Beginning in 2004, Fitch started to develop operating subsidiaries specializing in enterprise risk management, data services, and finance-industry training with the acquisition of a Canadian company, Algorithmics, and the creation of Fitch Solutions and Fitch Learning.

Moody’s Investors Service

John Moody and Company first published Moody’s Manual of Industrial and Miscellaneous Securities in 1900. The manual published basic statistics and general information about stocks and bonds of various industries.

From 1903 until the stock market crash of 1907, Moody’s Manual was a national publication. In 1909, Moody began publishing Moody’s Analyses of Railroad Investments, which added analytical information about the value of securities.

Expanding this idea led to the 1914 creation of Moody’s Investors Service, which in the following 10 years would provide ratings for nearly all of the government bond markets at the time. By the 1970s, Moody’s began rating commercial paper and bank deposits, becoming the full-scale rating agency that it is today.

S&P Global

In 1860, Henry Varnum Poor first published the History of Railroads and Canals in the United States, the forerunner of securities analysis and reporting that developed over the next century. The Standard Statistics Bureau, formed in 1906, published corporate bond, sovereign debt, and municipal bond ratings. Standard Statistics merged with Poor’s Publishing in 1941 to form Standard & Poor’s Corporation.

Standard & Poor’s Corporation was acquired by the McGraw-Hill Companies in 1966, and in 2016, the company rebranded as S&P Global. It has become best known for indexes such as the S&P 500, introduced in 1957, a stock market index that is both a tool for investor analysis and decision-making and a U.S. economic indicator.

Importance of Credit Ratings

Credit ratings for borrowers are based on substantial due diligence conducted by the rating agencies. Though a borrowing entity will strive to have the highest possible credit rating because it has a major impact on interest rates charged by lenders, the rating agencies must take a balanced and objective view of the borrower’s financial situation and capacity to service and repay the debt.

A credit rating determines not only whether or not a borrower will be approved for a loan but also the interest rate at which the loan will need to be repaid. As companies depend on loans for many startup and other expenses, being denied a loan could spell disaster, and a high-interest-rate loan is much more difficult to pay back. A borrower's credit rating should play a role in determining which lenders to apply to for a loan. The right lender for someone with great credit likely will be different than for someone with good or even poor credit.

Credit ratings also play a large role in a potential investor’s decision as to whether or not to purchase bonds. A poor credit rating is a risky investment. That's because it indicates a larger probability that the company will be unable to make its bond payments.

Credit ratings are never static, which means borrowers must remain diligent in maintaining a high credit rating. They change all the time based on the newest data, and one negative debt will bring down even the best score.

Credit also takes time to build up. An entity with good credit but a short credit history is not viewed as positively as another entity with equally good credit but a longer credit history. Debtors want to know if a borrower can maintain good credit consistently over time.

Considering how important it is to maintain a good credit rating, it's worth looking into the best credit monitoring services and perhaps choosing one as a means of ensuring your information remains safe.

Credit Ratings Scale

While each rating agency uses a slightly different scale, they each assign ratings as a letter grade for long-term debts. A rating of AAA is the highest possible credit rating, while a rating in the D's or C's is the lowest.

The rating scales for long-term debt at the three leading agencies are illustrated below:

Note that there are further divisions in each letter rating. For example, S&P assigns a + or - for ratings between CCC and AA, indicating a slightly higher or lower level of creditworthiness. For Moody's, the distinction is made by adding a number between 1 and 3: A Baa2 issuance is slightly more creditworthy than a Baa3 issuance, and slightly less so than one rated Baa1.

Investment Grade vs. Speculative Ratings

The range of possible credit ratings is divided into two categories: investment and non-investment-grade debt.

Investment-Grade Ratings

Government or corporate borrowers with a rating between BBB and AAA are considered to have investment-grade credit. These are extremely low-risk borrowers, who are considered very likely to meet all of their payment obligations. Because there is high demand for their debt, these companies or governments can usually borrow money at extremely low interest rates.

Non-Investment Ratings

A credit rating of BB or lower indicates non-investment or speculative-grade debt. The derisive term "junk bonds" is also used for these borrowers, indicating the perceived likelihood that they are at risk of default, or have already done so. However, there is one advantage to these types of bonds: they typically pay out higher interest to the bondholder.

Factors That Affect Credit Ratings

Credit agencies consider several factors when rating a potential borrower. First, an agency considers the entity’s past history of borrowing and paying off debts. A history of missed payments, defaults, or bankruptcies can negatively impact the rating.

The agency also looks at the borrower's cash flows and current debt levels. If the organization has steady income and the future looks bright, the credit rating will be higher. If there are any doubts about the borrower's economic outlook, their credit rating will fall.

These are some of the factors that can influence the credit rating of a company or government borrower:

• The organization's payment history, including any missed payments or defaults.
• The amount they currently owe, and the types of debt they have.
• Current cash flows and income.
• The market outlook for the company or organization.
• Any organizational issues that might prevent timely repayment of debts.

Note that credit ratings involve some subjective judgments, and even an organization with a spotless payment history can be downgraded if the rating agency believes that its ability to make repayments has changed.

For example, in 2011, Standard and Poor's reduced the credit rating of United States sovereign bonds from AAA to AA+, in response to Congressional roadblocks that could have caused a default. Even though the government ultimately made all of its payments on time, even the mere discussion of nonpayment was enough to cause a more negative outlook on U.S. government debt.

Frequently Asked Questions

The Bottom Line

Credit ratings are the corporate equivalent of a personal credit score. Instead of the 300-850 scale of an individual FICO score, debts by business or government borrowers are rated on a scale of D to AAA. These credit ratings indicate the likelihood that a borrower can make punctual repayments. A low credit rating can lead to higher interest rates on a borrower's loans and ultimately lead to greater financial issues down the road.