What is a Credit Rating?
Credit Ratings are scoring reports published by independent credit agencies (e.g. S&P Global, Moody’s, Fitch) on the risks of a company defaulting on its financial obligations.
- What are credit ratings?
- Who are the “Big Three” credit rating agencies?
- What is the difference between investment-grade and speculative-grade debt?
- How are credit ratings used in practice?
Credit Rating Definition
Credit ratings provide guidance to the public regarding the perceived default risk of a borrower and to frame the interest rate for lenders to charge.
The credit rating of a company refers to the assessment of its creditworthiness as a borrower by a credit agency.
Credit ratings are intended to be unbiased opinions on a particular company’s relative creditworthiness.
For investors, these ratings provide transparency and an objective report from which to form a view (and improve their investment decision-making).
More specifically, the credit rating quantifies risk and applies a scoring system to determine the likelihood that a borrower might:
- Default on Debt Obligations – e.g. Mandatory Principal Amortization, Interest Expense
- Overleveraged Capital Structure – i.e. Current Debt Burden Exceeds (or Near) Debt Capacity
The credit assessments – to minimize the chance of a potential conflict of interest – are conducted by independent credit rating agencies that specialize in evaluating credit risk.
Credit Rating Agencies (S&P, Moody’s & Fitch)
In the U.S., the three leading credit rating agencies – often called the “Big Three” – are listed below:
For companies seeking to raise debt financing, a report backing their credit health from a reputable credit agency can aid in their capital raising efforts – i.e. to be able to raise enough capital, debt with lower interest rates, etc.
However, all credit ratings from any agency warrant a closer look to identify the rationale behind the scoring, as all credit ratings – just like equity research analysts and investors – are prone to bias and mistakes.
For example, the “Big Three” credit rating agencies received scrutiny during the subprime mortgage crisis in 2007/2008 for their inaccurate designations of mortgage-backed securities (MBS) and collateralized debt obligations (CDO).
Since then, the SEC has implemented additional and stricter rules to reduce the chance of conflicts of interests and more disclosure requirements for how credit ratings are determined, particularly for structured products.
Credit Rating Scoring System
The scoring system utilized by credit agencies measures the relative likelihood of whether an issuer may repay its financial obligations on time and in full. This system is denoted in letter grades.
For instance, the credit ratings published by S&P Global range from “AAA” (i.e. lowest credit risk) to “D” (i.e. highest credit risk).
Broadly, debt issuances can be categorized as either:
- Investment-Grade – Low Risk of Default, Strong Credit Profile, Lower Interest Rates
- Speculative-Grade (or “High-Yield”/“Junk”) – High Risk of Default, Weak Credit Profile, Higher Interest Rates
Companies rated as investment-grade are less prone to defaulting on their debt obligations (and restructuring/bankruptcy), with the opposite being true for a company with a speculative-grade rating.
Factors Determining Credit Ratings
Credit ratings are a function of:
- Consistent Free Cash Flows (FCFs)
- High-Profit Margins (e.g. Gross Profit Margin, Operating Margin, EBITDA Margin, Net Profit Margin)
- Track Record of Timely Debt Payments
Using the above financial data, the agencies independently build out models to estimate the company’s credit risk, namely considerations such as:
Generally, high credit ratings are perceived as positive signs, whereas low credit ratings signify a company at risk of default.