Credit Rating
What is Credit Rating?
A credit rating is a rating agency's graded opinion of how likely a borrower is to repay its debt in full and on time.
Agencies such as Moody's, S&P Global Ratings and Fitch assign letter grades to bonds and to the companies and governments that issue them. The scales run from the top grade (AAA, or Aaa at Moody's) down through the letters to categories that signal default. Anything rated BBB minus and above, or Baa3 and above in Moody's notation, is called investment grade; below that line a bond is speculative grade, often called high yield or junk. The rating shapes the interest rate a borrower must offer, because lenders demand a larger default risk premium from weaker credits, so a downgrade raises the cost of every new bond that issuer sells. A rating is an opinion about repayment probability only, not a valuation of the bond and not a household credit score.
Credit Rating: a worked example
Two firms each borrow $100 million on the same day. The highly rated firm places its bonds at a 4 percent coupon, while the speculative-grade firm has to offer 7 percent to attract buyers. That 3 percentage point gap costs the weaker borrower 0.03 × $100 million = $3 million in extra interest every year, and $30 million over a ten-year bond. If the stronger firm is later downgraded and its next issue prices at 5 percent instead of 4 percent, the downgrade adds $1 million a year on the same $100 million.
The mistake students make with credit rating
Students read a credit rating as a verdict on how good a company is or how profitable it will be. It measures one thing: the chance the borrower fails to pay what it owes. A fast-growing company can carry a weak rating because it has borrowed heavily, while a slow-growing utility can be rated highly because its cash flows are steady. Ratings are opinions rather than guarantees, and highly rated debt has defaulted before.
Credit Rating questions
What is the difference between investment grade and junk bonds?
Investment grade means a rating of BBB minus or Baa3 and above, signalling a relatively low chance of default, while junk (speculative grade) sits below that line and must pay a higher interest rate to attract lenders. Many pension funds and insurers are restricted to investment grade holdings. A downgrade across that boundary can therefore force them to sell.
Who assigns credit ratings?
Credit ratings are assigned by private agencies, chiefly Moody's, S&P Global Ratings and Fitch. Under the usual arrangement the issuer selling the bonds pays the agency to rate them, which critics say creates a conflict of interest. Agencies publish their methodologies and revise ratings as an issuer's finances change.
What happens when a country's credit rating is downgraded?
A sovereign downgrade generally raises the interest rate the government must pay on new borrowing, because lenders now judge default to be less unlikely. It can also force funds that are permitted to hold only highly rated debt to sell what they own. Borrowing costs for banks and companies in that country usually rise as well.
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