Before debt issuers lend money to a company or government entity, they usually want to gauge the track record of the borrower. One way to do this is through the use of credit ratings. Common credit rating agencies that help assess an entity’s credit worthiness include Moody’s Investor Services, Standard and Poor’s (S&P), and Fitch Group.
Credit ratings are different from credit scores, which are issued to everyday consumers. While credit ratings use letter grades to assess a company or government entity, credit scores use numbers to assess individuals.
Keep reading to learn more about what a credit rating is, the types of credit ratings that exist, and how credit rating agencies work.
How Do Credit Ratings Work?
A credit rating is a type of score determined by a credit rating agency that assesses whether an entity is capable of paying back their debts within an agreed timeline. The primary goal of a credit rating is to measure the risk involved when lending money to a company or government entity. The rating can help a borrower determine how likely that entity is to default on their loan.
When a credit rating is high, it means in the credit rating agency’s opinion, the potential borrower is reliable and likely to repay their debt on time. Contrarily, when the rating is low, the assumption is that said entity is high risk and more likely to pay late or default on their loan.
Credit ratings can be used by both debt issuers and investors looking to evaluate an entity’s reliability. For instance, an investor may check a government entity’s credit worthiness before putting their hard earned money in a bond. In cases where a borrower is high risk and has a low rating, sometimes they offer higher compensation in the form of interest.
Some factors used to determine credit ratings include payment history, current debt balances, cash flow, and income. The general market economic outlook may be used as a factor in ratings too.
Types of Credit Ratings
There are two general categories credit rating agencies use to determine the risk of a borrower. They include an investment grade and a speculative grade.
Investment grade: Investment grade is used to categorize borrowers who have proven themselves trustworthy. Since these borrowers are reliable, they don’t tend to pay investors as much interest.
Speculative grade: Entities that are high-risk are categorized as speculative investments. As mentioned, these entities are usually willing to give investors incentives for borrowing them money since they carry more risk.
Credit Rating Agencies
Credit rating agencies provide information about a borrower’s ability to repay debt and interest on time. The three credit rating agencies that dominate the market include Moody’s Investor Services, Standard and Poor’s (S&P), and Fitch Group. All three agencies have slight nuances but use similar rating styles.
S&P Global ratings: Entities that have a rating of BBB and above are considered investment grade. Grades of BB and lower fall into the speculative grade bucket.
Moodys: With this credit rating agency, a grade of Baa3 and higher is considered investment grade. Non-investment grades comprise grades of Ba1 and below.
Fitch Group: Companies and government entities with a grade of BBB and higher is categorized as an investment grade, while BB and lower is speculative.
Before lending money as an investor, it’s important to do research, which includes knowing how creditworthy the prospective borrower is. If you’re unsure how to navigate this process, consider speaking to a financial advisor beforehand.
