Executive Summary
-
A credit rating is an opinion from a credit rating agency about the creditworthiness of an issuer or the credit quality of a particular debt instrument.
-
Primarily, the rating opinion considers how likely the issuer of the debt instrument is to meet its stated obligations, and whether investors will receive the payments they were promised.
-
A failure to meet such payments may be considered a default.
Introduction
There are three major international rating agencies in the United States: Standard & Poor’s Ratings Services (a unit of The McGraw-Hill Companies), Moody’s Investors Service, and Fitch Ratings (a unit of Fimalac SA). In addition, there are many regional and niche rating agencies that tend to specialize in a geographical region or industry. The major agencies state that their opinions of the credit quality of securities are based on established, consistently applied, and transparent ratings criteria. Although the agencies use different criteria, definitions, and rating scales, they each state a view on the probability that an entity or security will default. Some rating agencies also assess the potential for recovery—how likely the investors are to recoup their investment in the event of default.
Issuers of most fixed-income securities issued in world financial markets request and receive a credit rating from a rating agency. Although credit rating evaluations are not always required, they may increase the marketability of a debt instrument by providing investors with an independent opinion about the instrument’s relative credit quality.
Why Do Corporations Request a Credit Rating?
A credit rating opinion is often required by investors before they purchase securities. Many investors want to see an established opinion about the credit quality of a security that is not from the issuer or underwriter. In addition, some funds have made it a requirement for their investment guidelines or as part of what they have promised their investors. Issuers who are not well known or who are trying to sell into international markets may benefit from a rating from a recognized rating agency.
The rating provides market participants with an opinion on the credit quality of a particular investment. Ratings from the major credit rating agencies have a strong track record, as reported in their default and transition studies. Over the long run, securities with a higher credit rating have consistently had lower default rates than securities with lower ratings. Ratings are just opinions, however, and there have been certain periods when highly rated securities in a specific sector ultimately performed worse than other securities rated in the same category. Accordingly, ratings do not remove the need for the investor to understand what he or she is buying.
The Standard & Poor’s rating scale is a simple and easy-to-understand shorthand for its credit opinions. A more detailed analysis is typically available from Standard & Poor’s, including the rationale behind the rating opinion. Investors are encouraged to read the detailed analysis carefully to understand why an agency assigned a particular rating.
Having a rating may be useful even if a corporation elects to raise money privately rather than through a public bond issue. Obtaining a rating may make it easier for a company to seek funding from a private lender or bank. Although not every company needs a credit rating, most medium-sized or larger firms find it useful.
- Page 1 of 5
- Next section How a Rating Is Assigned
www.qfinance.com