Credit Ratings Simplified

Investors all over the world rely on credit ratings issued by credit agencies. Despite the doubt surrounding some of these ratings in the aftermath of the 2008 global financial crisis, it is still widely used as a risky business benchmark.

Credit ratings provide a sense of how safe a debt investment is. That is, whether they will get their money back. A better rating means investors are more likely to get back the amount they lent, with interest on top.

For companies, credit ratings affect borrowing costs. A good credit rating means a company can issue debt at lower interest rates, as the risk of holding the debt is judged to be lower. The converse is true.

For countries, the impact extends to the other asset markets. As some investors can only invest in countries with an investment-grade rating, an upgrade from speculative to investment-grade status could see funds flow in.

A measure of creditworthiness

Credit ratings measure how able a country or company is to repay its debt. In other words, its creditworthiness. Ratings agencies are paid to form an opinion of how likely the country or company is to default. The world’s three largest agencies are Standard & Poor’s (S&P), Moody’s Investors, and Fitch Ratings.

Going beyond the hard numbers

The analysis is not a pure science, as analysts have to look beyond the hard numbers to determine an appropriate credit rating.

When issuing a sovereign debt rating, agencies look at how stable the political climate and economy are, and if the country has a history of default. A country may be able to pull itself out of debt woes, but if the debt card is flashed too easily, it may not try as hard to make their debt and interest payments. In a recurring and ongoing debt nightmare, Europe - and how it exits its debt crisis - appears to be held hostage over how Greek debt is repaid and rated.

For companies, the evaluation includes the industry and markets it operates in, the strength of the business itself, and specific risk factors such as clauses in the bond’s structure that may provide added protection against default, or the quality and reliability of future cash flows (e.g. toll road fees) to fund debt repayments.

Analysts then assign a rating based on an alphabetical scale, with AAA (by S&P) the top rating, and D the lowest. More broadly, the ratings can be seen as investment grade and speculative or ‘junk’. (Figure 1).

Credit ratings are not…

There are some common misconceptions about credit ratings, and we try to address them here. In short, credit ratings are not…

  • buy/hold/sell recommendations. Risk profile, existing investment portfolio, investment goal, and time horizon matter too. For instance, most investors fled Ireland bonds when its debt woes hogged headlines. But some who believed Ireland would pull through, and had the resources and time to ride through the volatility, stocked up on Irish bonds. Yields fell from 8.4% at the start of 2012 to 4.6% in November, translating into handsome profits.
  • absolute predictors of default. A top-rated company or country can still default due to unexpected developments. Lehman Brothers declared bankruptcy on 15 September 2008, and major insurance company AIG accepted a US government bailout the next day despite both commanding top quality credit ratings. This was virtually unthinkable then.
  • guarantees of future valuations. In the lead-up to the US housing bubble, subprime mortgages were bundled and sold with AAA credit rating tags, as analysts thought there was a slim chance that all the mortgages would default at the same time. Investment funds flooded these assets. But as the bubble unraveled, these bundles were swiftly downgraded, and the values of the investment dropped drastically.
  • a prerequisite for creditworthiness. It’s not always the case that the issuer of a non-rated bond has cash problems. Issuers may find it enough to rely on another party’s rating, or may not want to pay the rating fee. For example, bonds issued by Singapore’s statutory boards are not rated, but yet are seen as safe because of the Singapore government’s AAA rating.
  • an indication of liquidity risk, which is the possibility of being unable to sell an asset quickly enough to avoid a loss. Financial markets froze when Lehman Brothers collapsed; buying and selling in debt markets practically ground to a halt, and even the bonds issued by companies with solid cash balances found no takers.
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Call Us: 1800 221 1111