Credit rating
Evaluation of credit risk for debtors by rating agencies.
Wikipedia / Wikimedia Commons
A credit rating is an evaluation of the credit risk of a prospective debtor, such as an individual, business, company, or government. It predicts or forecasts the ability of a supposed debtor to pay back debt or default, based on qualitative and quantitative information provided by the debtor and non-public information obtained by analysts. Credit reporting, or credit score, is a subset of credit rating, specifically a numeric evaluation of an individual's credit worthiness done by a credit bureau.
- field
- Finance, credit risk assessment
- known_for
- Evaluating creditworthiness of debtors, including sovereign entities and corporations
- major_agencies
- Standard & Poor's, Moody's, Fitch Ratings, DBRS, A. M. Best
- rating_scales
- Letter designations (e.g., AAA, AA, A, B, C) with plus/minus or numbers
- short_term_horizon
- One year or under
- long_term_horizon
- Above one year
Lore & Background
Credit ratings are assigned by agencies such as Standard & Poor's, Moody's, and Fitch Ratings, which control approximately 95% of the business. They use letter designations like A, B, C, with higher grades intended to represent a lower probability of default. Agencies do not attach hard default probabilities to each grade, preferring descriptive definitions; for example, Standard & Poor's defines an AAA-rated bond as having 'extremely strong' capacity to meet financial commitments, while a BB-rated bond is 'less vulnerable to non-payment than other speculative issues.' Studies have estimated average risk and reward: Moody's found that over a five-year horizon, its highest rating (Aaa) had a cumulative default rate of 0.18%, while the lowest studied (B2) had 31.24%.
Reader's Guide
Credit ratings are significant because they influence investment decisions, particularly for sovereign and corporate debt. Sovereign credit ratings indicate the risk level of a country's investing environment, factoring in political risk. For example, Euromoney's country risk index monitors 185 countries, with Singapore often the least risky since 2017 and one of the few with AAA ratings from all major agencies. Ratings also affect borrowing costs: a study in the Journal of Finance found that from 1973 to 1989, AAA-rated corporate bonds paid 43 basis points over US Treasury bonds, while CCC-rated 'junk' bonds paid over 7% more. In Europe, ratings are under scrutiny because they determine how much banks can borrow against sovereign debt, with the European Central Bank using the highest rating among S&P, Moody's, Fitch, and DBRS for collateral requirements. The legacy of credit ratings lies in their role as a standardized tool for assessing default risk, though their accuracy and methodology remain subjects of debate.
Did You Know?
- Credit reporting (or credit score) is a subset of credit rating, focusing on individuals.
- Singapore, Hong Kong (a Special Administrative Region of China), Australia, and Japan are the only Asian territories to have ever achieved AAA sovereign credit ratings from all three major agencies.
- Moody's highest rating (Aaa) had a cumulative default rate of 0.18% over a five-year horizon, while its lowest studied (B2) had 31.24%.
- The European Central Bank uses the highest rating among S&P, Moody's, Fitch, and DBRS to determine collateral requirements for banks.
Frequently Asked Questions
What exactly is a credit rating?
A credit rating is a professional assessment of how likely a debtor—whether an individual, corporation, or government—is to repay its obligations. Analysts review both public financial data and non-public information to produce a judgment about default risk.
Who are the main credit rating agencies?
The most widely recognized agencies are Standard & Poor's, Moody's, and Fitch Ratings, with DBRS and A. M. Best also operating in the space. Their opinions are used by investors, lenders, and regulators worldwide to gauge creditworthiness.
What do the letter grades like AAA or B+ actually represent?
Ratings use a letter-based scale (AAA down to C) with plus or minus modifiers to indicate relative credit risk, where AAA signals the lowest likelihood of default and lower letters signal progressively higher risk. These designations apply to both short-term (one year or under) and long-term (beyond one year) obligations.
How is a credit rating different from a credit score?
A credit score is a numeric value that a credit bureau assigns to an individual's creditworthiness, while a credit rating is a broader qualitative-and-quantitative evaluation that can cover individuals, companies, or sovereign governments. In other words, a credit score is a narrow subset within the wider credit-rating framework.
Why do credit ratings matter to investors and markets?
They give market participants a standardized, third-party signal of default probability, which directly influences the interest rates a borrower must pay and how much capital it can raise. Without these assessments, pricing debt instruments would rely far more heavily on each investor's own due diligence.
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