Credit rating

A credit rating is an evaluation of the credit risk of a prospective debtor (an individual, a business, company or a government), predicting their ability to pay back the debt, and an implicit forecast of the likelihood of the debtor defaulting.[1] The credit rating represents an evaluation of a credit rating agency of the qualitative and quantitative information for the prospective debtor, including information provided by the prospective debtor and other non-public information obtained by the credit rating agency's analysts.

A credit reporting (or credit score) – in distinction to a credit rating – is an evaluation of an individual's credit worthiness, which is done by a credit bureau or consumer credit reporting agency.

Sovereign credit ratings

A sovereign credit rating is the credit rating of a sovereign entity, such as a national government. The sovereign credit rating indicates the risk level of the investing environment of a country and is used by investors when looking to invest in particular jurisdictions, and also takes into account political risk.

Country risk rankings (Q1 2016)[2][3] Least risky countries, Score out of 100 Source: Euromoney country risk
Rank Rank Change Country Overall Score
1 1 Norway 88.59
2 -1 Switzerland 87.95
3 0 Singapore 86.49
4 0 Luxembourg 85.14
5 0 Netherlands 84.49
6 0 Denmark 83.87
7 0 Sweden 83.49
8 0 Germany 82.49
9 0 Canada 82.04
10 0 Finland 81.09

The "country risk rankings" table shows the ten least-risky countries for investment as of January 2013. Ratings are further broken down into components including political risk, economic risk. Euromoney's bi-annual country risk index monitors the political and economic stability of 185 sovereign countries.[4] Results focus foremost on economics, specifically sovereign default risk or payment default risk for exporters (also known as a trade credit risk).

A. M. Best defines "country risk" as the risk that country-specific factors could adversely affect an insurer's ability to meet its financial obligations.[5]

Short-and long-term-ratings

A rating expresses the likelihood that the rated party will go into default within a given time-horizon: 1 year (short-term) or above (long-term). In the past institutional investors preferred to consider long-term ratings. Nowadays, short-term ratings are commonly used.

Corporate credit ratings

Main article: Bond credit rating

Credit ratings can address a corporation's financial instruments i.e. debt security such as a bond, but also the corporations itself. Ratings are assigned by credit rating agencies, the largest of which are Standard & Poor's, Moody's and Fitch Ratings. They use letter designations such as A, B, C. Higher grades are intended to represent a lower probability of default.

Agencies do not attach a hard number of probability of default to each grade, preferring descriptive definitions such as: "the obligor's capacity to meet its financial commitment on the obligation is extremely strong," or "less vulnerable to non-payment than other speculative issues ..." (Standard and Poors' definition of an AAA-rated and a BB-rated bond respectively).[6] However, some studies have estimated the average risk and reward of bonds by rating. One study by Moody's[7][8] claimed that over a "5-year time horizon" bonds it gave its highest rating (Aaa) to had a "cumulative default rate" of 0.18%, the next highest (Aa2) 0.28%, the next (Baa2) 2.11%, 8.82% for the next (Ba2), and 31.24% for the lowest it studied (B2). (See "Default rate" in "Estimated spreads and default rates by rating grade" table to right.) Over a longer period, it stated "the order is by and large, but not exactly, preserved".[9]

Estimated spreads and
default rates by rating grade
Rating Basis
Point
spread
[10][11][12]		 Default
rate[7][8]
AAA/Aaa430.18%
AA/Aa2730.28%
A99n/a
BBB/Baa21662.11%
BB/Ba22998.82%
B/B240431.24%
CCC724n/a
Sources: Basis spread from
Federal Reserve Bank of
New York Quarterly Review,
Summer-Fall 1994";
Default rate from study
by Moody's investment service

Another study in Journal of Finance calculated the additional interest rate or "spread" corporate bonds pay over that of "riskless" US Treasury bonds, according to the bonds' rating. (See "Basis point spread" in table to right.) Looking at rated bonds for 1973–89, the authors found a AAA-rated bond paid 43 "basis points" (or 43/100 of a percentage point) over a US Treasury bond (so that it would yield 3.43% if the Treasury yielded 3.00%). A CCC-rated "junk" (or speculative) bond, on the other hand, paid over 7% (724 basis points) more than a Treasury bond on average over that period.[10][11]

Different rating agencies may use variations of an alphabetical combination of lower-case and upper-case letters, with either plus or minus signs or numbers added to further fine-tune the rating (see colored chart). The Standard & Poor's rating scale uses upper-case letters and pluses and minuses.[13] The Moody's rating system uses numbers and lower-case letters as well as upper case.

While Moody's, S&P and Fitch Ratings control approximately 95% of the credit ratings business,[14] they are not the only rating agencies. DBRS's long-term ratings scale is somewhat similar to Standard & Poor's and Fitch Ratings with the words high and low replacing the + and −. It goes as follows, from excellent to poor: AAA, AA (high), AA, AA (low), A (high), A, A (low), BBB (high), BBB, BBB (low), BB (high), BB, BB (low), B (high), B, B (low), CCC (high), CCC, CCC (low), CC (high), CC, CC (low), C (high), C, C (low) and D. The short-term ratings often map to long-term ratings though there is room for exceptions at the high or low side of each equivalent.[15]

S&P, Moody's, Fitch and DBRS are the only four ratings agencies that are recognized by the European Central Bank (ECB) for determining collateral requirements for banks to borrow from the central bank. The ECB uses a first, best rule among the four agencies that have the designated ECAI status,[16] which means that it takes the highest rating among the four agencies – S&P, Moody's, Fitch and DBRS – to determine haircuts and collateral requirements for borrowing. Ratings in Europe have been under close scrutiny, particularly the highest ratings given to countries like Spain, Ireland and Italy, because they affect how much banks can borrow against sovereign debt they hold.[17]

A. M. Best rates from excellent to poor in the following manner: A++, A+, A, A−, B++, B+, B, B−, C++, C+, C, C−, D, E, F, and S. The CTRISKS rating system is as follows: CT3A, CT2A, CT1A, CT3B, CT2B, CT1B, CT3C, CT2C and CT1C. All these CTRISKS grades are mapped to one-year probability of default.

Moody's S&P Fitch Rating description
Long-term Short-term Long-term Short-term Long-term Short-term
Aaa P-1 AAA A-1+ AAA F1+ Prime
Aa1 AA+ AA+ High grade
Aa2 AA AA
Aa3 AA− AA−
A1 A+ A-1 A+ F1 Upper medium grade
A2 A A
A3 P-2A− A-2 A− F2
Baa1BBB+BBB+ Lower medium grade
Baa2 P-3 BBBBBB F3
Baa3BBB−A-3 BBB−
Ba1 Not Prime BB+BBB+ B Non-investment grade
speculative
Ba2 BBBB
Ba3 BB−BB−
B1 B+B+ Highly speculative
B2 BB
B3 B−B−
Caa1 CCC+CCCC+C Substantial risks
Caa2 CCC CCC
Caa3 CCC−CCC−
Ca CC CC Extremely speculative
C C Default imminent
C RDDDDDDIn default
/ SDDD
/ DD

See also

Individuals:

References

  1. ↑ Kronwald, Christian (2009). Credit Rating and the Impact on Capital Structure. Norderstedt, Germany: Druck und Bingdung. p. 3. ISBN 978-3-640-57549-7.
  2. ↑ "Country risk survey - previous ranking from previous quarter, Euromoney Country risk". Euromoney.com.
  3. ↑ "Country Risk Full Results": Originally a bi-annual survey which monitors the political and economic stability of 185 sovereign countries, according to ratings agencies and market experts. The information is compiled from Risk analysts; poll of economic projections; on GNI; World Bank’s Global Development Finance data; Moody’s Investors Service, Standard & Poor’s and Fitch IBCA; OECD consensus groups (source: ECGD); the US Exim Bank and Atradius UK; heads of debt syndicate and loan syndications; Atradius, London Forfaiting, Mezra Forfaiting and WestLB.
  4. ↑ "Country risk survey". Euromoney.com.
  5. ↑ "Country Risk". ambest.com. Retrieved 2011-08-08.
  6. ↑ Sinclair, Timothy J. (2005). The New Masters of Capital: American Bond Rating Agencies and the Politics of Creditworthiness. Ithaca, New York: Cornell University Press. p. 36, Bond Rating Symbols and Definitions, Table 2,. ISBN 978-0801474910. Retrieved 21 September 2013.
  7. 1 2 Cantor, R., Hamilton, D.T., Kim, F., and Ou, S., 2007 Corporate default and recovery rates. 1920-2006, Special Comment: Moody's investor Service, June Report 102071, 1-48 page 24
  8. 1 2 cited by authors Herwig Langohr and Patricia Langohr
  9. ↑ Langohr, Herwig; Patricia Langohr (2010). The Rating Agencies and Their Credit Ratings: What They Are, How They Work. Wiley. p. 48.
  10. 1 2 Cantor, Richard; Packer, Frank (Summer–Fall 1994). "The credit rating industry" (PDF). Federal Reserve Bank of New York Quarterly Review. Federal Reserve Bank of New York. p. 10. ISSN 0147-6580. Archived from the original (PDF) on 2011-04-29.
  11. 1 2 from Altman, Edward I "Measuring Corporate Bond Mortality and Performance" Journal of Finance, (September 1989) p. 909–22
  12. ↑ Note: Based on equally weighted averages of monthly spreads per rating category. Spreads for BB and B represent data from 1979 to 1987 only, spreads for CCC, data for 1982–87 only.
  13. ↑ de Servigny, Arnaud; Olivier Renault (2004). The Standard & Poor's Guide to Measuring and Managing Credit Risk. McGraw-Hill. ISBN 978-0-07-141755-6.
  14. ↑ Alessi, Christopher. "The Credit Rating Controversy. Campaign 2012". Council on Foreign Relations. Retrieved 29 May 2013.
  15. ↑ "DBRS: Short-Term and Long-Term Rating Relationships" (PDF). DBRS. Retrieved 2013-06-28.
  16. ↑ "External credit assessment institution source (ECAIs)". European Central Bank. Retrieved 21 January 2014.
  17. ↑ Jones, Marc (19 December 2013). "First crunch date in Europe's ratings calendar is April 11". Reuters. Retrieved 21 January 2014.
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