A corporate credit rating is a numeric or quantified creditworthiness evaluation of a company, showing investors the risk of a company falling back on its debt obligations or existing bonds.
Rating agencies issue corporate credit ratings. By providing independent, objective evaluations of companies and countries’ creditworthiness, a credit rating agency or company allows investors to determine how risky it is to invest in a particular country, security, or bond.
Firstly, it is crucial to bear in mind that corporate credit ratings are an opinion, not a fact. Learn more about what precisely corporate credit ratings are as you read on.
Who Are the Raters, and How Do They Rate?
The three major providers of corporate credit ratings are Standard & Poor, Moody, and Fitch. Every agency has its own rating system, which does not inherently conform to the other agencies’ rating scale, but they are all comparable.
For instance, “AAA” is used by Standard & Poor for the highest credit rating with the lowest credit risk, and “AA” for the next best. Followed by “A”, then “BBB” for satisfactory credit.
These ratings are considered investment grade — the security or business being graded holds a quality level that many organizations demand. Anything below “BBB” is deemed risky or worse, down to a “D” level that suggests default or “junk”.
Ratings can be allocated to short-term and long-term debt obligations issued by a government or a corporation, like banks and insurance firms. Therefore, ratings measure the ability of an entity to pay debts in both international and local currencies.
Criticism of Corporate Credit Ratings
A major criticism is that issuers compensate credit rating agencies for assessing their securities. This became extremely crucial when the growing real estate market peaked in 2006-2007, and the agencies rated a considerable amount of subprime debt.
The possibility of receiving high payments caused rivalry among the three major agencies to issue the highest possible ratings. During the 2008 Financial Crisis, businesses that had previously received stellar ratings from numerous credit rating agencies have been brought down to junk levels.
They have questioned the ratings’ reliability. The persistent concern with troubling rating agencies is that they are not genuinely impartial because the issuers themselves pay rating agencies.
As per critics, a rating agency could give the issuer a rating it wanted or could sweep anything under the rug that would adversely affect a positive credit rating, to secure the job to conduct a rating.
Resolving Potential Conflicts
To help solve the credit rating agencies’ potential conflicts of interest, the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act required amendments to monitor and control credit rating agencies.
The regulations require credit rating agencies to report publicly how their ratings are done. They are also held responsible for erroneous ratings, which they should have learned.
Whether it handles a mutual fund, hedge fund, or provides its clients with wealth management services, a good investment firm or bank will not depend exclusively on a credit agency bond rating to decide whether an investment is safe.
The in-house research department will usually help make the decision, which is why investors must conduct analysis and due diligence by checking the initial bond rating and periodically examining ratings for any improvements over the investment’s existence.
A credit rating is a valuable tool not only for the investor, but also for investment-seeking entities. An investment-grade rating can help attract both domestic and foreign investments.
A strong credit rating is essential for developing economies to show international investors their creditworthiness. A better rating also usually means lower interest rates, decreasing default chances in a rising rate environment.