Credit rating is the most important feature of the financial world. It provides a measure to evaluate the risk involved with debt investments. It is, therefore, one of the most important tools both investors, financial institutions, and governments use in making decisions on borrowing and lending.
A credit rating is essentially a grade assigned to any borrower-whatever form that borrower may take, be it person, firm, or government-about how good it can be at repaying debt on time.
In this article, we’re going to talk about the concepts of credit ratings, the various types of credit ratings, the role of credit rating companies, and give actual examples of their impact.
What is Credit Rating?
Credit evaluation signifies the process of measuring ability of the borrower to pay for the financial burdens derived from debts.
After detailed examination and review of the borrower’s financial conditions, a CRA or a credit rating agency gives rating.
The financial condition can involve looking into their previous credit history, the solidity of the economy, and then checking their power to produce cash flows.
The CRA assigns a rating of the grade received, from low risk that is given with the highest grade to high risk with the lower grade.
A credit rating mainly indicates the level of possible risk that may be incurred to an investor for providing finances to a lender.
The rate also determines how much interest there must be added on debts by a borrower.
Thus, a highly rated borrower by the level of credits pays less at interest rates whereas low-rated levels of credits through borrowing attract interest rates that pay a borrower as an attraction process for investors.
Types of Credit Rating
Credit ratings can be broadly categorized into two: credit ratings for entities, which may be a corporation or government, and credit ratings for financial products such as bonds or loans.
Among these, various specific rating types are assigned according to the borrower’s financial condition and the level of risk involved.
1. Long-term credit ratings
Long-term credit ratings are assigned to debt whose term is more than a year. Ratings will consider debtor’s capacity to repay debt in the long run and at prevailing as well as potential future conditions. Examples of long-term credit ratings include:
• AAA: The highest ranking; they will have a superb capacity of borrower to meet up with the fiscal obligations. Rating entities in the AAA are safest investments, extremely unlikely to result in default.
• AA: This has also been scored as strong rating but slightly down-ranked by AAA. That is, they represent excellent strength, very nearly at par; the borrower appears to be so safe with slight risk of even default.
• A: These borrowers show a good potential to service obligation but are there a slight prospect of slipping within the cycles of economy as well as commercial cycles from their highly reliable categories of AA and AAA.
• BBB: This rating grade, BBB, would be classified financially sound but is highly vulnerable to a bad economy. They are graded good enough in respect of their ability and are thus enabled to service their obligation comfortably but become most vulnerable when economies get worse in financial performance.
• BB and below: These grades are on a higher risk level. The investments graded as BB or lower are speculative. They have a high risk of default, hence investors are paid more to assume this risk.
2. Short-Term Credit Grade
A short-term rating is that credit rating applied to the less than one-year maturities debt instrument. This credit rating examines the capability of a borrower to repay the short-term debt, which gives an impression of how stable a borrower will be in the near future.
In general, a short-term rating would include:
• A-1 (or equivalent): The highest short term rating, and the debtor shall be in a position to service its short-term debt almost with absolutely certainty.
• A-2: Rating one level below A-1 means that the debtor has the capacity to pay short-term obligations, but he requires more risk.
• B: Such scores denote a high-risk level; there is a problem with the ability of the borrower to pay for his short term obligations.
• C: This is a very low score, so the borrower will likely not meet his or her short-term obligations for cash.
They are very speculative borrowers.
3. Credit Rating Agencies
Independent bodies that assess the creditworthiness of the borrower regarding debt securities, rating agencies are independent evaluation entities that give an overall view of its qualification for investment.
Thus, these ratings by the credit rating companies enable a distinction of the amount of risk undertaken for a specific investment.
They are based on detailed financial analysis and economic data apart from other information regarding its activities.
Examples of the most popular and recognized credit rating agencies:
1. Moody’s Investors Service
The legendary agency has founded itself in 1909 and has depended on proving financial reliability with ratings for corporations, governments, and financial products ever since.
At Moody’s, its rating scale ranges
from AAA to C, which is a benchmark for assessing risk in the financial world.
Such Moody’s ratings represent the most fundamental metrics that aid investors and even more so market players in navigating finance with confidence by being known and respected for its credibility. Moody’s, the name rolls around the globe when talking about credit ratings.
2. (S&P) Standard & Poor’s
The ratings of this behemoth, from giant companies to cities and towns, clearly give investors a sense of how much risk lies in lending to either government or corporate borrowers and can range from AAA, the best ranking, to the worst D grade.
This source is understood to be trenchant in its insight, and as such, with its influence reverberating globally, S&P is an entity of crucial importance to the investor in an environment as precarious as this where financial ambiguity lies.
One of the oldest and most prestigious credit rating agencies on earth, Standard and Poor, was founded as back as 1860.
3. Fitch Ratings
Fitch is a global credit rating company that offers ratings, research, and analysis to financial institutions, investors, and other parties.
Fitch assigns credit ratings to corporations, governments, and structured financial products. The ratings scale used by Fitch goes from AAA to D, which indicates a default status.
Fitch has been acclaimed for its very tight analytical approach and can provide much information regarding the general world economic condition and financial stability.
Actual World Examples of Credit Rating
To better illustrate the impact of credit ratings to both borrowers and investors, here are actual world examples:
1. U.S. Treasury Bonds
Bonds with this type of rating carry no risk and are totally safe investments because the full faith and credit of the United States stands behind them.
Due to the absence of a danger of default, such U.S. Treasury Bonds naturally enjoy lower yields compared to low-rated bonds. U.S. government bonds usually enjoy a AAA rating,
which is the best possible rating for any bond.
2. Corporate Bonds (Apple)
Apple Inc, one of the largest and one of the best companies in the world, usually bonds itself in the rating of about AA+.
Such a rating comes high owing to the very good financial health of the company, its increasingly regular profitable conditions, and a very high market share.
This automatically leads to the offering of very low interest rates to investors since the chance of default is almost negligible.
3. Emerging Market Bonds (Brazil)
Investors in such bonds would, of course, be expecting a greater return since it carries higher default risk. Countries whose economies are relatively unstable would issue bonds carrying a lower rating; for instance, Brazil could well be rated at BB. A BB rating indicates higher risk, which is often associated with political instability or economic challenges.
The Influence of Credit Ratings on Global Financial Markets
The purposes of credit rating in the financial market are diversified and mainly tied with two aspects: namely, investment options and the operations of debt markets.
1. Investment Decisions
Credit ratings serve as a very important factor in establishing the risk in investing in any particular instrument.
An investor would usually rely on rating to ascertain whether or not he should buy a certain bond or other kind of debt instrument and how much return he can gain from an investment against how much risk it may hold.
2. Market Liquidity
Credit ratings create liquidity in the markets by providing for a uniform style of rating different debt instruments, which ensures everyone understands the credit rating scale to compare various debt securities sold by these sectors.
Such a scenario then makes it moderately easy to allocate your capital and ensure diversification on your portfolio
3. The Cost of borrowing
Risk management: the credit rating of the borrower directly determines the cost of borrowing.
It will have low interest rate in borrowing for those entities that are well-rated as they are deemed to be at minimal risk.
Entities with poor ratings, however might be made to have high costs for borrowing as their investments will pose a risk on their finances.
4. Risk management
Credits form a useful benchmark for both the financial institution participants and the institutional market players when there is the management of credit-related risks.
Using the credit rating, institutions compute their degree of exposure to such risks of credits whereas institutional investors design diversified portfolios.
This matches some level of accepted risk within desired investment horizons.
Conclusion
Credit ratings are very important tools in the financial markets and help investors make judicious lending decisions to various borrowers based on the risks that are involved.
There are long-term ratings and short-term ratings. These ratings give the position of the borrower regarding the paying off debts which he incurs upon himself as a result of his health and the general economic environment prevailing at the time.
The most basic credit rating companies to the ratings are Standard & Poor’s, Moody’s, and Fitch. These help in transparency and the balance of global financial markets to the balance of stability.
Credit ratings and categories allow investors to understand how to work in the financial world with more confidence through an understanding of these types of ratings and their impacts on borrowing and lending.
Credit ratings from investors are necessary in dealing with government bonds, corporate debt, or sovereign bonds from emerging markets to enable them to identify levels of risk, understand investment decisions, and manage their respective portfolios.
From this perspective, credit ratings therefore form the mainstay of the modern finance scenario so as to constantly maintain the precarious balance between reward and risk across all investments.
Frequently Asked Question
1. Which are the 5 C’s of Credit Rating?
5 C’s of Credit Rating is a criteria of evaluation applied by the lenders about the credit worthiness of a borrower. It has five parameters for evaluating, that are as follows:
- Character: The credit reputation of the borrower in terms of reliability and behavior with previous experience of debt payments.
- Capacity: This pertains to assessing his capacity to pay off the loan, whereby one will calculate income level and his financial status, based on which repayment capacity is established.
- Capital: It is the money or assets invested by the borrower forming a cushion of financial downturn
- Collateral: In which the assets are offered by the borrower to service the loan, thus minimizing risks for the lender in case of inability by the borrower to service his obligations and
- Conditions: These include, among other external factors, conditions surrounding the economy and specific industry trends. The nature or purpose of the loan might impact the ability to repay the same.
2. The 7 P’s of Credit?
These are the 7 Ps of credit guiding the consideration that creditors make when adjudging the credit-worthiness of a borrower. They are
- Personality, the character, integrity, and reliability of the borrower;
- Payment History, the borrower’s past record in the repayment of debts;
- Purpose, the purpose for which the money is borrowed and whether such purpose is legal or not.
- Prospects, that is, the ability of the borrower to generate future income or profits;
- Protection, that is, the collateral or security given to secure the loan;
- Powers, that is, the legal capacity of the borrower to enter into a credit agreement; and
- Position, which represents the financial position and standing of the borrower in their industry or market.
3. The 5 Pillars of Credit?
These 5 credit pillars are what form the base used in the decision-making of a credit application for a lending process.
Character is how responsible and reliable the borrower is perceived to be.
This is usually estimated through credit history, while capacity reflects the capability of the borrower to repay debt based on income, employment, and debt-to-income ratio.
The funds available to the borrower for a loan are capital. These could be personal savings and investments.
Collateral is essentially an asset that is pledged for the loan, while conditions are broad market and economic conditions which might impact on a borrower’s ability to repay.
4. What is CIBIL?
It’s also known by its full name of Credit Information Bureau India Ltd. Credit information company which collates credit data of a huge number of individual and business firms.
Through such records, credit scores are evolved to be computed in order for the lenders for evaluation of credibility on an individual as well as the business organization scale.
5. What is Good Credit Score?
Here, the debtor would more likely to pay off his debts on due time. So, for that, this individual would hold lower risk for the lender.
Sometimes, it will offer an even better loan deal such as lesser interest rates.
Again, what is considered “good” is to a large extent subjective in nature among rating agencies and lenders.
A good credit score is generally between 700 and 750.
6. What is the Highest Possible Credit Score?
Based on the scorecard, pretty much any credit score would qualify itself as perfect if it falls in the range between 850 and 900.
For example, in FICO, which is limited to 300-850, 850 is the highest score achievable and signifies a level of creditworthiness classified as excellent.
Other scoring systems like VantageScore may push the maximum to a total of 900.
In short, it makes it look as if the applicant has used credit responsibly and maintained on-time payments, very low credit utilization, and indeed very little debt throughout his or her entire history.