Credit Rating (CRA)

Editor: Matias

Text Words marked with a * will be explained in the glossary

What is it?

Credit ratings are an independent assessment of a firm’s/government’s creditworthiness*. These can be thought of as credit scores* for entities (firms and governments).

The ratings are issued by credit rating agencies (CRAs) such as FitchRatings, Moody’s, or S&P. The CRA industry is highly concentrated* with these 3 players accounting for 90%+ of this market.

How does it work?

Credit ratings gauge the level of risk involved in buying an entity’s bonds*/lending to that entity.

A high rating implies that the corporation/government is likely to repay its debts without difficulties. A low rating implies the opposite.

Investors base their decisions on this: high ratings (AAA to BBB) signal relative safety and so lower interest rates. Low ratings (BB to D) signal risk, commanding higher interest rates.

CRA ratings scale:

Reproduced from WallStreetPrep

Determining ratings:

The CRAs consider many factors when issuing credits, such as the entity’s:

Debt payments history (past defaults/missed payments?)
The amount of capital it currently owes others
The types of debts it has
Current income & cash flows
Overall macro trends/economic outlook
Other unique issues

Importance of CRA:

Despite criticism for their role in the 2008 financial crisis, and huge market influence, CRAs play important roles in the financial system:

Help investors make capital-allocation decisions
Highly-rated entities can more easily access capital (lower costs of capital)
Poor entities more easily identified, making the system more efficient

Glossary:

Creditworthiness: The likelihood of an entity/person defaulting on their debt obligations.
Credit scores: Numerical rating system to measure a person’s creditworthiness.
Concentrated industry: An industry/market with few powerful players, characterized by high entry barriers.
Bonds: Financial instrument representing money lent by an investor to a borrower.

sources: Investopedia & Investopedia