Credit Rating

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What is Credit Rating?

Credit rating (CR) is an evaluation of an entity's creditworthiness based upon its current financial condition and past credit history. In other words it is an opinion of the relative degree of risk associated with timely payment of interest and principal on a debt instrument.

Normally a simple alphanumeric symbol is used to convey a particular CR (see below for examples).

Users of Credit Ratings

CRs are used by investors, bond issuers, investment banks, broker-dealers, and governments as a benchmark to assess the future ability of a particular creditor to pay back loans (credit risk). The CR acts as one of the inputs in their investment decision. But there are also other inputs for investors, such as the expected return on the debt instrument and their portfolio strategy (diversification).

Issuers of Bonds

The following entities typically issue securities (bonds):

• Corporations
• National, state and local governments
• Special Purpose Entities

Usage of Credit Ratings

CRs are crucial for investors to determine the level of risk they're taking when they are buying corporate bonds or state bonds.

For the issuers, the ratings will affect the interest rate that is applied to the particular security being issued. That is why the relationship with rating agencies is an important element of the external corporate governance of corporations.

Examples of Credit Ratings

Typically such rating takes the form of a short letter code, like AAA, A3, A-, B1, CC+, D etc. The best investment quality being AAA or Aaa.

These ratings are the result of the proprietary credit scoring statistical system of each credit agency. Typically both quantitative elements (company size, available capital) as well as qualitative elements (quality of management) are used.

Downgrading and Upgrading

Ratings are based on certain expectations and assumptions about variables that impact the issuer's performance. These variables can be either company-specific factors, industry factors or factors related to the economy as a whole. When these variables change, rating agencies will change their ratings accordingly.

Downgrading means a rating is lowered, for example from A+ to A, or from A1 to A2. As a result of a downgrade, the value of the bond will normally decrease.

Upgrading means a rating is raised, for example from AA to AA+, or from Aa2 to Aa1. As a result of an upgrade, the value of the bond will normally increase.

CR Bureaus

CR agencies provide credit information to creditors, such as banks and businesses, to help them decide what is the level of risk involved in issuing a loan or extend a credit. Based on the ratings, an appropriate interest rate can be determined.

There are 3 major credit agencies (the Big Three):

• Standard & Poor’s
• Moody’s Investors Service
• Fitch

Besides that there are a number of other CR agencies, such as:

• Dominion Bond Rating Service
• A.M. Best Company
• Japan Credit Rating Agency, Ltd.
• Egan-Jones Rating Company
• Morningstar, Inc.

Potential Conflicts of Interest

• The function of credit agencies is to inform investors about the creditworthiness of issuers of bonds. However the issuers of bonds are paying the credit agencies for their ratings.
• Certain credit agencies are also consulting issuers about possibilities to improve their rating. This compromises their independency.

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