Credit Ratings and Credit Rating Agencies

If you invest in bonds, you have probably come across credit ratings. Credit ratings usually appear in the form of alphabetical letter grades (for example, "AAA" and "BBB") and are an estimate of the relative level of credit risk of a bond or a company or government. Credit ratings are issued by third parties and are not an assessment by the issuer or the regulators.

Credit ratings can be useful when evaluating an investment. But when considering credit ratings, one should understand their limitations. One should not base their investment decision solely on a credit rating as if it were investment advice.

What is Credit Rating

A credit rating is an assessment of an entity's ability to pay its financial obligations. The ability to pay financial obligations is referred to as credit worthiness. Credit ratings aply to debt securities like bonds, notes, and other debt instruments (for example, some asset-backed securities). Credit ratings also are assigned to companies and governments. They do not apply to equity securities like common stock.

A credit rating agency assesses the credit worthiness of an entity that is usually called an obligor or issuer. Obligors include entities such as corporations, financial institutions, insurance companies, or municipalities.

Credit ratings generally reflect a relative ranking of credit risk. For example, an obligor or debt security with a high credit rating is assessed by the credit rating agency to have a lower likelihood of default (that is, not paying back its debt) than an issuer or debt security with a lower credit rating.

Credit rating agencies use rating scales, symbols, and definitions to express credit risk. Most use a scale of letters and/or numbers, and these symbols are defined by the particular credit rating agency issuing those ratings. A typical credit rating scale has a top rating of "AAA" and may have a lowest rating of "D" (indicating default). Some credit rating agencies scales distinguish between investment grade and non-investment grade (i.e. speculative or high yield) ratings and they draw this distinction between the "BBB" and "BB" rating categories (in other words, a rating that is "BBB-" or higher is investment grade and a rating that is lower than "BBB-" is non-investment grade.)

For example, the following is the rating scale of Standard & Poor (S&P).

Rating Grade Meaning
AAA Investment Grade Extremely strong capacity to meet financial commitments
AA Investment Grade Very strong capacity to meet financial comitments
A Investment Grade Strong capacity to meet financial commitments, but somewhat susceptible to economic conditions and changes in circumstances
BBB Investment Grade Adequate capacity to meet financial commitments, but more subject to adverse economic conditions
BB Speculative Grade Less vulnerable in the near-term but faces major ongoing uncertainities to adverse business, financial and economic conditions
B Speculative Grade More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments
CCC Speculative Grade Currently vulnerable and dependent on favourable business, financial and economic conditions to meet financial commitments
CC Speculative Grade Highly vulnerable; default has not yet occured, but is expected to be a virtual certainity
C Speculative Grade Currently highly vulnerable to non-payment, and ultimate recovery is expected to be lower than that of higher rated obligations
D Speculative Grade Payment default on a financial commitment or breach of an imputed promise; also used when a bankruptcy petition has been filed

What a credit rating is not

A credit rating does not reflect other types of risk, such as market or liquidity risks, which may also affect the value of a security. Nor does a credit rating consider the price at which the security is offered or sold. One should never interpret a credit rating as investment advice and should not view it as a recommendation to buy, sell or hold securities.

A credit rating is not a guarantee that a financial obligation will be repaid. For example, a "AAA" credit rating on a debt instrument does not mean the investor will always be paid - instruments rated at this level sometimes default.

A credit rating is an assessment of the creditworthiness of a debt instrument or obligor, based on a credit rating agency's analytical models, assumptions, and expectations. A credit rating may reflect a credit rating agency's subjective judgement of an issuer's business and management. While historical financial and operating experience and collateral performance may factor into the analysis, credit ratings are simply a prediction of the likelihood that an obligor will repay the obligation in future. The predictions are based on the views of the credit rating agency, which may differ from your view and those of other industry participants.

Credit rating changes can happen at any time, without warning, and at any rating level. Some credit rating agencies provide rating "outlooks" and rating "watches" to formally alert investors about potential revisions to those ratings. Even still, these alerts may not precede every rating action.

One should understand the information that credit ratings are intended to convey and any limitations to the ratings. One should also evaluate the bond's prospectus or other documents that provide financial information, industry news and reports, and non-credit-related factors to determine whether an investment is suitable or not.

Who uses Credit Ratings?

The following use credit ratings.

Intermediaries Investors

Some prominent Credit Rating Agencies

The following are some of the prominent credit agencies in the world.
  1. Fitch
  2. Standard & Poor Rating Services
  3. Moody's Investors Services
There are many other credit rating agencies but the above are the most prominent ones.

Steps in Rating Process

The following are some of the steps involved in the credit rating process.
  1. Contract: The issuer requests a rating and signs an engagement letter.

  2. Pre-Evaluation: The rater assembles a team of analysts to review pertinent information.

  3. Management Meeting: Analysts meet with management team to review and discuss information.

  4. Analysis: Analysts evaluate information and propose the rating to a rating committee.

  5. Rating Committee: The committee reviews the lead analyst's rating recommendation then votes on the credit rating.

  6. Notification: The rater generally provide the issuer with a pre-publication rationale for its credit rating for fact-checking and accuracy purposes

  7. Publication: The rater typically publishes a press release announcing the public rating and posts the rating on its website.

  8. Surveillance of Rated Issuers and Issues: A continued surveillance is done to keep the rating current by identifying issues that may result in either an upgrade or a downgrade.

Potential conflicts of interest in credit ratings

Many credit rating agencies - including the largest agencies - are paid by the obligors they rate or by the issuers of the securities they rate. This creates a potential conflict of interest in that the credit rating agency may be influenced to determine more favourable (i.e. higher) ratings than warranted to retain the obligors or issuers as client and to obtain new obligor or issuer clients.

Alternatively, some credit rating agencies are paid by subscribers to their ratingss service, which are usually investors. Investors' desire for low or high credit ratings, depending on their holdings and trading positions, may also present a conflict of interest.

Why do investors use credit ratings?

When making investment decisions, credit ratings and any related rating and industry trend reports can be helpful tools, provided one uses them appropriately. Credit ratings may offer an alternative point of view to one's own financial analysis or that of a financial adviser.

Credit ratings may enable one to compare the risks among investments in a portfolio. Considering the credit ratings of multiple credit rating agencies may be useful because they may offer diverse views on the credit worthiness of an investment.

In general, if one uses credit ratings, they should be in addition to, and not a replacement of, one's own research, analysis and judgement to determine whether an investment best satisfies the needs. One must note that credit ratings address credit risk only. They do not address other risks such as liquidity risk, interest rate or market risk, or prepayment risk.

Credit ratings are subjective

There are no standards or agreed-upon methods to measure the accuracy of credit ratings. This is partly because of the subjective nature of credit ratings. Also, the performance of credit ratings may not be comparable across different industry sectors, meaning that defaults and rating changes (or "transitions" of an issuer's or debt instrument's rating from one rating to another) may not be consistent for each rating category across the sectors. For example, default rates for corporate bonds historically have been greater than default rates for municipal bonds with the same credit ratings.

Even within an industry sector, transistion and default rates may differ over time and in different geographic regions. Inconsistencies in performance can be attributable to change in business cycles and economic environments that do not impact all obligors equally and at the same time.

In terms of comparing credit ratings performance across credit rating agencies, one should know that definitions for what their credit ratings mean differ among credit rating agencies. Credit rating agencies also use different analytical approaches and levels of subjectivity when determining credit ratings.

Credit rating agencies may differ in the time horizon that their rating address. For example, some credit agencies aim for stability in ratings so they assume a longer term horizon in their analysis. Other credit rating agencies prefer to address short-term risks and events, which can lead to more variability in their ratings. Additionally, some credit rating agencies' ratings only reflect the likelihood that an obligor will default, while others' ratings also consider the expected loss that may result from a default.

Rating scale of Moody's Investor Services

Rating Grade Meaning
Aaa Investment Grade These are judged to be of the higest quality, subject to the lowest level of credit risk
Aa Investment Grade These are judged to be of high quality and are subject to very low credit risk
A Investment Grade These are judged to be upper-medium grade and are subject to a low credit risk
Baa Investment Grade These are judged to be medium-grade and subject to moderate credit risk and as such may possess certain special characteristics
Ba Speculative Grade These are judged to be speculative and are subject to high credit risk
Caa Speculative Grade These are judged to be speculative of poor standing and are subject to a very high credit risk
Ca Speculative Grade These are highly speculative and are likely in, or very near, default, with some prospect of recovery of principal and interest
C Speculative Grade These are lowest rated and are typically in default, with little prospect of recovery of principal or interest

Rating Scale of Fitch

The following is the rating scale of Fitch.

Rating Credit Quality Grade Meaning
AAA Highest Credit Quality Investment Grade This denotes the lowest expectation of default risk. These are assigned only in cases of exceptionally strong capacity for payment of financial commitments. This capacity is highly unlikely to be adversely affected by foreseeable events.
AA Very High Credit Quality Investment Grade This denotes expectations of very low default risk. They indicate very strong capacity for payment of financial commitments. This capacity is not significantly vulnerable to foreseeable events.
A High Credit Quality Investment Grade This denotes expectations of low default risk. The capacity for payment of financial commitments is considered strong. This capacity may nevertheless be more vulnerable to adverse business or economic conditions than is the case for higher ratings.
BBB Good Credit Rating Investment Grade This rating indicate that expectations of default risk are currently low. The capacity for payment of financial commitments is considered adequate, but adverse business or economic conditions are more likely to impair this capcity.
BB Speculative Speculative Grade This rating indicates an elevated vulnerability to default risk, particularly in the event of adverse changes in business or economic conditions over time; however, business or financial flexibility exists that supports the servicing of financial commitments.
B Highly Speculative Speculative Grade This indicates that material default risk is present, but a limited margin of safety remains. Financial commitments are currently being met; however, capacity for continued payment is vulnerable to deterioration in the business and economic environment.
CCC Substantial Credit Risk Speculative Grade Default is a real possibility
CC Very High Levels of Credit Risk Speculative Grade Default of some kind appears probable
C Near Default Speculative Grade A default or default-like process has begun, or the issuer is in standstill, or for a closed funding vehicle, payment capacity is irrevocably impaired
RD Restricted Default Speculative Grade RD ratings indicate an issuer that in Fitch's opinion has experienced an uncured payment default or distressed debt exchange on a bond, loan or other material financial obligation, but has not entered into bankruptcy filings, administration, receivership, liquidation, or other formal winding-up procedure, and has not otehrwise ceased operating.
D Default Speculative Grade D ratings indicate an issuer that in Fitch's opinion has entered into bankrutpcy filings, administration, receivership, liquidation or other formal winding-up procedure or that has otherwise ceased business.


Updation History
First updated on 8th September 2020.