Monday, August 8, 2011

What is a Credit Rating?

A credit rating evaluates the credit worthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government. It is an evaluation made by credit rating agency of the debt issuers likelihood of default

Credit ratings are determined by credit ratings agencies. The credit rating represents the credit rating agency's evaluation of qualitative and quantitative information for a company or government; including non-public information obtained by the credit rating agencies analysts. Credit ratings are not based on mathematical formulas. Instead, credit rating agencies use their judgment and experience in determining what public and private information should be considered in giving a rating to a particular company or government. The credit rating is used by individuals and entities that purchase the bonds issued by companies and governments to determine the likelihood that the government will pay its bond obligations.

What are the agencies that provide Credit Ratings?

Though each bank may have an internal rating system for large organizations and sovereign parties (Countries), the 3 most important or widely accepted rating agencies are:

1. Standard & Poors
2. Moody's
3. Fitch

A point to note is that the above agencies are not in any order of importance and the ratings by each agency is considered with equal importance. If two or more agencies provide a rating for a party, then it is widely accepted as the credit worthiness of the party.

What are the Rating Bands?

The rating bands issued by the rating agencies are grouped as follows:

1. Prime Investment Grade
2. High Investment Grade
3. Medium Grade
4. Speculative/Risky
5. High Risk
6. In Default

Where are these Ratings used?

These are used when investors buy debt instruments (bonds) issued by these parties. If I were to invest my money in a bond and I have 3 options, one Prime, one Medium and one High Risk, I will obviously choose the Prime rated company's bonds because, they are the least risky and they will repay the money they owe me in due time without any delays or defaults.

However, if the rating is not prime and falls in the other categories, companies usually offer a higher rate of interest to attract investors to invest in them (even though they are risky)

Remember the Risk - Return matrix? Higher the risk, higher the returns. Obviosly, there is a risk that the party may default, but they pay more nonetheless.

What are the actual Ratings?

Based on the Rating Bands that we just saw, the ratings from the respective agencies are:

Prime Investment Grade: No Risk of Default

Rating Agency Rating
Moody Aaa
Fitch AAA

High Investment Grade:

Rating Agency Rating
S&P AA+, AA, AA-
Moody Aa1, Aa2, Aa3
Fitch AA+, AA, AA-

Upper Medium Grade:

Rating Agency Rating
S&P A+, A
Moody A1, A2
Fitch A+, A

Lower Medium Grade:

Rating Agency Rating
Moody A3, Baa1, Baa2, Baa3
Fitch A-, BBB+, BBB, BBB-

Non Investment Grade/Speculative:

Rating Agency Rating
S&P BB+, BB, BB-
Moody Ba1, Ba2, Ba3
Fitch BB+, BB, BB-

Highly Speculative:

Rating Agency Rating
S&P B+, B, B-
Moody B1, B2, B3
Fitch B+, B, B-

Extremely Risky:

Rating Agency Rating
Moody Caa1, Caa2, Caa3, Ca
Fitch CCC

In Default:

Rating Agency Rating
Moody C
Fitch DDD, DD, D

As you can see, AAA is the best and D is probably the worst possible credit rating you can get.

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