Credit Rating
Credit ratings are assessments provided by specialized companies that evaluate the creditworthiness of organizations, including businesses and governments, based on their ability to repay debts. These ratings play a crucial role in the fixed-income market, influencing the interest rates that companies must pay when issuing bonds or obtaining loans. Major credit rating firms—Standard & Poor's (S&P), Moody's Investor Service, and Fitch Ratings—assign ratings that range from the highest quality (AAA or Aaa) to categories indicating default risk (C/D or Ca/C). The ratings reflect the likelihood of default and, consequently, the perceived risk of an investment.
Investors utilize these ratings to guide their investment decisions, especially in determining the risk/return trade-off associated with different securities. Higher-rated securities typically offer lower returns, as they are considered safer, while lower-rated (or "junk") bonds present greater risks but also higher potential returns. Credit ratings are essential tools for investors, helping them make informed choices and manage their portfolios according to their risk tolerance. However, despite the insights provided by these ratings, ongoing vigilance is necessary, as a rating can change over time, impacting the value and reliability of an investment.
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Credit Rating
Companies must have access to capital (money) if they hope to take advantage of opportunities to expand or launch new products. They can obtain this capital by borrowing it from a bank or by issuing bonds or other fixed-income securities. Bonds are investments that pay interest over the course of time. The interest rate a company must pay for a loan or on a bond that it issues is based on the possibility of the company failing to repay the loan or to make good on the bond. Rating companies routinely assign credit ratings to major companies. The belief is that the better the credit rating a company has, the less likely it is that it will default on the payments. The three main credit rating companies are Standard & Poor’s (S&P), Moody’s Investor Service, and Fitch Ratings.
Background
Fixed-income securities guarantee a specific return upon maturity. The maturity of a security can be as short as thirty days or as long as thirty years. Investors pay a set amount of money at the original offering and receive their principal plus the promised interest upon the maturity of the fixed-income security. (It’s possible to sell a fixed-income security before the maturity date. A range of factors impact the price the investor will receive, not the least of which is the availability of other instruments with a similar rating and interest rate.)
The promise to pay a given sum in thirty years is not useful if the company no longer exists at the time of the maturity date. There needs to be a reason to believe, therefore, that the company will be able to pay as promised, and one way to do that is for an individual to investigate the company’s financials and prospects. Another way is to use credit ratings assigned to the company by the three major credit rating firms. In general, if there is some doubt as to the company’s future potential to repay its debts, the rating will reflect that.
Standard & Poor’s was founded as Standard Statistics in 1906. Ratings assigned by S&P range from AAA for the highest quality investments to C/D for companies that are either not making payments or are in bankruptcy. Moody’s first published its Moody’s Manual in 1900. Moody’s ratings range from Aaa down to Ca/C. Founded in 1913, Fitch ratings range from AAA to DDD, DD, D. Ratings assigned by these three companies are respected because of their rigorous independent research into a company or bond offering. The ratings are accepted as reliable indicators of the best information available at the present time.
Impact
Credit ratings have played an integral part in the fixed income sector, because they are accepted as a reliable evaluation of the long-term financial health of a business, government, or municipality. This rating is the risk side of the risk/return trade-off of a fixed-income security. Investors who are very risk averse use the ratings to invest in corporate bonds, federal debt instruments, and municipal offerings rated as high or highest quality. Investment portfolios for retirement funds, real estate investment companies, and others with large reserves of cash to invest usually have specified ratings they must meet in their investments. Credit ratings provide a shorthand note to potential investors as well as a wealth of information to the fixed-income investor.
The risk/return trade-off is in effect because investors demand a higher return on an investment with a greater risk. This is the reason that government securities such as Treasury bonds pay far lower rates than corporate bonds, even corporate bonds of the highest quality. The perception among investors is that federal governments and sovereignties will keep their promise to pay. As creditworthy as a private company may be, there is always some amount of risk that something unforeseen will occur during the investment timeframe that will then leave the company unable to pay. As a general rule, the rate paid for the highest rated and least risky securities will serve as the basis for all other rates, with adjustments made to those rates for additional risk.
It is possible to invest in fixed-income securities that are considered "junk." Junk bonds carry ratings of BB or lower from S&P, Ba or below from Moody’s, and BB or lower from Fitch, because they are more likely to be affected by changes in economic conditions than other investments might be. Because of the significant level of risk, the return on these fixed income investments will be significantly higher than those of fixed-income securities of the highest quality.
One of the reasons an investor purchases a fixed-income security is that the interest is paid on fixed dates over the life of the investment. The investor reinvests these dividends at the then-going rate. When making these investments, an investor may decide to go with a riskier investment, or the investor may decide to maintain the risk level by investing in fixed-income securities with the same rating or higher.
The fact that a corporation or bond issue is viewed favorably on a particular day doesn’t guarantee that the corporation will pay out as promised thirty years from that day, which is why investors in fixed-income securities with a significant time until maturity keep an eye on the ratings and activity in the investment community. Even with the ratings to serve as a guide, the individual investor must still protect his or her interest by staying informed of developments that may affect the fixed-income security before its maturity date.
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