Credit rating

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Standard & Poor's

Fitch Ratings logo

Credit rating is a quantified assessment of the creditworthiness of a borrower in general terms or with respect to a particular debt or financial obligation. A credit rating can be assigned to any entity that seeks to borrow money—an individual, corporation, state or provincial authority, or sovereign government.

Credit rating evaluations are conducted by credit rating agencies such as Standard & Poor's, Moody's Investors Service, and Fitch Ratings. These agencies evaluate the credit risk of the issuer of debt and assign a rating that reflects their assessment of the issuer's ability to make debt payments. The rating influences the interest rate that a debtor pays. A high credit rating indicates a high probability of paying back the loan in its entirety without any issues, whereas a low credit rating suggests a high risk of defaulting.

History

The concept of credit ratings began in the early 20th century when the demand for independent market information increased. Initially, credit ratings were primarily focused on the railroads, the largest issuers of debt at the time, and later expanded to include governments and corporations. The first credit rating agency, John Moody and Company, was established in 1909, which later became Moody's Investors Service.

Types of Credit Ratings

Credit ratings are categorized into two main types: long-term and short-term ratings. Long-term ratings reflect the creditworthiness of a borrowing entity over a long period, while short-term ratings are concerned with the borrower's ability to repay short-term debt obligations.

Long-term Credit Ratings

Long-term credit ratings are usually assigned to specific bonds, loans, or other financial obligations with a maturity of more than one year. They range from 'AAA' to 'D', where 'AAA' represents the highest credit quality and 'D' indicates a default on financial obligations.

Short-term Credit Ratings

Short-term credit ratings evaluate the likelihood of a borrower defaulting within a year. These ratings range from 'A-1' to 'D'. Like long-term ratings, a 'D' rating signifies a default.

Factors Influencing Credit Ratings

Several factors can influence an entity's credit rating, including:

• Financial Performance: The entity's past and projected financial performance, including profitability, cash flow, and leverage.
• Debt Levels: The amount and types of debt held by the entity.
• Economic Conditions: The general economic environment and its impact on the entity's operations and financial stability.
• Political and Regulatory Environment: The political and regulatory issues that could affect the entity's ability to repay its debt.
• Management Quality: The effectiveness of the entity's management team in executing its business strategy and managing its finances.

Impact of Credit Ratings

Credit ratings have a significant impact on the financial markets. They affect the interest rates that borrowers must pay on their debts. Entities with high credit ratings can borrow money at lower interest rates, reflecting the lower risk of default. Conversely, entities with low credit ratings will face higher borrowing costs. Credit ratings also influence the investment decisions of investors, as they use these ratings to assess the risk level of various investment opportunities.

Controversies

Credit rating agencies have faced criticism, especially in the wake of financial crises. Critics argue that conflicts of interest may arise because the entities that issue debt are also the ones that pay for the ratings. There have been concerns about the accuracy of credit ratings and the agencies' ability to assess credit risk properly.