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