Credit rating

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A credit rating is an evaluation of the credit risk of a prospective debtor (an individual, a business, company or a government). It is the practice of predicting or forecasting the ability of a supposed debtor to pay back the debt or default. [1] . The credit rating represents an evaluation from 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.

Contents

Credit reporting (or credit score) is a subset of credit rating. It is a numeric evaluation of an individual's credit worthiness, which is done by a credit bureau or consumer credit reporting agency.

Sovereign credit ratings

Country risk rankings (Q4 2017) [2] [3] Least risky countries, Score out of 100Source: Euromoney country risk
RankRank ChangeCountryOverall Score
1- Singapore 88.6
2- Norway 87.66
3- Switzerland 87.64
4- Denmark 85.67
5▲2 Sweden 85.59
6▼1 Luxembourg 83.85
7▼1 Netherlands 83.76
8▲4 Finland 83.1
9- Canada 82.98
10▲1 Australia 82.18

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.

The "country risk rankings" table shows the ten least-risky countries for investment as of January 2018. 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, with Singapore emerging as the least risky country since 2017 – it is also one of the only few countries in the world as well as the only in Asia to achieve a AAA sovereign credit rankings from all major credit agencies. [4] [5]

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. [6]

Short and long-term ratings

A rating expresses the likelihood that the rated party will go into default within a given time horizon. In general, a time horizon of one year or under is considered short term, and anything above that is considered long term. In the past institutional investors preferred to consider long-term ratings. Nowadays, short-term ratings are commonly used.[ citation needed ]

Corporate credit ratings

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). [7] However, some studies have estimated the average risk and reward of bonds by rating. One study by Moody's [8] [9] 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". [10]

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. [11] [12]

Different rating agencies may use variations of an alphabetical combination of lowercase and uppercase 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 uppercase letters and pluses and minuses. [13] The Moody's rating system uses numbers and lowercase letters as well as uppercase.

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.

Under the EU Credit Rating Agency Regulation (CRAR), the European Banking Authority has developed a series of mapping tables that map ratings to the "Credit Quality Steps" (CQS) as set out in regulatory capital rules and map the CQS to short run and long run benchmark default rates. These are provided in the table below:


Moody's Standard & Poor's Fitch Ratings Rating descriptionEU Credit Quality Step [18] [19] [20] Long run benchmark default rates (mid value) [21] Short run benchmark default rates (trigger level) [21]
Long-termShort-termLong-termShort-termLong-termShort-term
AaaP-1AAAA-1+AAAF1+Prime10.1%1.2%
Aa1AA+AA+High grade
Aa2AAAA
Aa3AA−AA−
A1A+A-1A+F1Upper medium grade20.25%1.3%
A2AA
A3P-2A−A-2A−F2
Baa1BBB+BBB+Lower medium grade31.0%3.0%
Baa2P-3BBBBBBF3
Baa3BBB−A-3BBB−
Ba1Not PrimeBB+BBB+BNon-investment grade
speculative		47.5%12.4%
Ba2BBBB
Ba3BB−BB−
B1B+B+Highly speculative520%35%
B2BB
B3B−B−
Caa1CCC+CCCC+CSubstantial risks634%not applicable
Caa2CCCCCC
Caa3CCC−CCC−
CaCCCCExtremely speculative
CCDefault imminent
CRDDRDDIn default
/SDD
/D/

Related Research Articles

In finance, a high-yield bond is a bond that is rated below investment grade by credit rating agencies. These bonds have a higher risk of default or other adverse credit events but offer higher yields than investment-grade bonds in order to compensate for the increased risk. As of 2024, high-yield bonds have a higher yield than U.S. Treasury securities.

<span class="mw-page-title-main">Bond (finance)</span> Instrument of indebtedness

In finance, a bond is a type of security under which the issuer (debtor) owes the holder (creditor) a debt, and is obliged – depending on the terms – to provide cash flow to the creditor. The timing and the amount of cash flow provided varies, depending on the economic value that is emphasized upon, thus giving rise to different types of bonds. The interest is usually payable at fixed intervals: semiannual, annual, and less often at other periods. Thus, a bond is a form of loan or IOU. Bonds provide the borrower with external funds to finance long-term investments or, in the case of government bonds, to finance current expenditure.

<span class="mw-page-title-main">Government bond</span> Bond issued by a government

A government bond or sovereign bond is a form of bond issued by a government to support public spending. It generally includes a commitment to pay periodic interest, called coupon payments, and to repay the face value on the maturity date.

<span class="mw-page-title-main">Debt</span> Obligation to pay borrowed money

Debt is an obligation that requires one party, the debtor, to pay money borrowed or otherwise withheld from another party, the creditor. Debt may be owed by a sovereign state or country, local government, company, or an individual. Commercial debt is generally subject to contractual terms regarding the amount and timing of repayments of principal and interest. Loans, bonds, notes, and mortgages are all types of debt. In financial accounting, debt is a type of financial transaction, as distinct from equity.

<span class="mw-page-title-main">S&P Global Ratings</span> American credit rating agency

S&P Global Ratings is an American credit rating agency (CRA) and a division of S&P Global that publishes financial research and analysis on stocks, bonds, and commodities. S&P is considered the largest of the Big Three credit-rating agencies, which also include Moody's Ratings and Fitch Ratings. Its head office is located on 55 Water Street in Lower Manhattan, New York City.

<span class="mw-page-title-main">Credit rating agency</span> Company that assigns credit ratings

A credit rating agency is a company that assigns credit ratings, which rate a debtor's ability to pay back debt by making timely principal and interest payments and the likelihood of default. An agency may rate the creditworthiness of issuers of debt obligations, of debt instruments, and in some cases, of the servicers of the underlying debt, but not of individual consumers.

In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the credit risk" or the risk of an event of default of a corporate or sovereign borrower, transferring it to an entity other than the lender or debtholder.

<span class="mw-page-title-main">Moody's Corporation</span> American business and financial services company

Moody's Corporation is an American business and financial services company. It is the holding company for Moody's Ratings, an American credit rating agency, and Moody's, an American provider of financial analysis software and services.

Fitch Ratings Inc. is an American credit rating agency. It is one of the three nationally recognized statistical rating organizations (NRSRO) designated by the U.S. Securities and Exchange Commission and is considered as being one of the "Big Three credit rating agencies", along with Moody's and Standard & Poor's.

<span class="mw-page-title-main">Moody's Ratings</span> Bond credits rating business of Moodys Corporation

Moody's Ratings, previously known as Moody's Investors Service and often referred to as Moody's, is the bond credit rating business of Moody's Corporation, representing the company's traditional line of business and its historical name. Moody's Ratings provides international financial research on bonds issued by commercial and government entities. Moody's, along with Standard & Poor's and Fitch Group, is considered one of the Big Three credit rating agencies. It is also included in the Fortune 500 list of 2021.

Sovereign credit is the credit of a sovereign country backed by the financial resources of that state. Sovereign credit is the opposite of sovereign debt. Fiat money is sovereign credit and sovereign bonds are sovereign debts. When money buys bonds, sovereign credit cancels sovereign debt.

Country risk refers to the risk of investing or lending in a country, arising from possible changes in the business environment that may adversely affect operating profits or the value of assets in the country. For example, financial factors such as currency controls, devaluation or regulatory changes, or stability factors such as mass riots, civil war and other potential events contribute to companies' operational risks. This term is also sometimes referred to as political risk; however, country risk is a more general term that generally refers only to risks influencing all companies operating within or involved with a particular country.

In investment, the bond credit rating represents the credit worthiness of corporate or government bonds. The ratings are published by credit rating agencies and used by investment professionals to assess the likelihood the debt will be repaid.

<span class="mw-page-title-main">Morningstar DBRS</span> Global credit rating agency

Morningstar DBRS is a global credit rating agency with offices in Toronto, New York, Chicago, London, Frankfurt and Madrid. Morningstar DBRS provides independent credit rating services for financial institutions, corporate and sovereign entities and structured finance products and instruments. It was originally founded as Dominion Bond Rating Service in Toronto in 1976, and its operations were integrated with Morningstar Credit Ratings to form Morningstar DBRS after its acquisition by the global financial services firm Morningstar, Inc. in 2019. It is the largest rating agency in Canada.

A structured investment vehicle (SIV) is a non-bank financial institution established to earn a credit spread between the longer-term assets held in its portfolio and the shorter-term liabilities it issues. They are simple credit spread lenders, frequently "lending" by investing in securitizations, but also by investing in corporate bonds and funding by issuing commercial paper and medium term notes, which were usually rated AAA until the onset of the financial crisis. They did not expose themselves to either interest rate or currency risk and typically held asset to maturity. SIVs differ from asset-backed securities and collateralized debt obligations in that they are permanently capitalized and have an active management team.

Credit rating agencies and the subprime crisis is the impact of credit rating agencies (CRAs) in the American subprime mortgage crisis of 2007–2008 that led to the financial crisis of 2007–2008.

<span class="mw-page-title-main">2000s European sovereign debt crisis timeline</span>

From late 2009, fears of a sovereign debt crisis in some European states developed, with the situation becoming particularly tense in early 2010. Greece was most acutely affected, but fellow Eurozone members Cyprus, Ireland, Italy, Portugal, and Spain were also significantly affected. In the EU, especially in countries where sovereign debt has increased sharply due to bank bailouts, a crisis of confidence has emerged with the widening of bond yield spreads and risk insurance on credit default swaps between these countries and other EU members, most importantly Germany.

Several credit rating agencies around the world have downgraded their credit ratings of the U.S. federal government, including Standard & Poor's (S&P) which reduced the country's rating from AAA (outstanding) to AA+ (excellent) on August 5, 2011.

The corporate debt bubble is the large increase in corporate bonds, excluding that of financial institutions, following the financial crisis of 2007–08. Global corporate debt rose from 84% of gross world product in 2009 to 92% in 2019, or about $72 trillion. In the world's eight largest economies—the United States, China, Japan, the United Kingdom, France, Spain, Italy, and Germany—total corporate debt was about $51 trillion in 2019, compared to $34 trillion in 2009. Excluding debt held by financial institutions—which trade debt as mortgages, student loans, and other instruments—the debt owed by non-financial companies in early March 2020 was $13 trillion worldwide, of which about $9.6 trillion was in the U.S.

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. Archived from the original on 2018-10-01. Retrieved 2018-01-16.
  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. ↑ Wright, Chris (9 March 2017). "Singapore leads the world in sovereign risk". Euromoney. Retrieved 26 May 2022.
  5. ↑ "Country risk survey". Euromoney.com. Archived from the original on 2018-10-01. Retrieved 2018-01-16.
  6. ↑ "Country Risk". ambest.com. Retrieved 2011-08-08.
  7. ↑ Sinclair, Timothy J. (2005). The New Masters of Capital: American Bond Rating Agencies and the Politics of Creditworthiness. Ithaca, NY: Cornell University Press. p. 36, Bond Rating Symbols and Definitions, Table 2. ISBN   978-0-80147491-0 . Retrieved 21 September 2013.
  8. ↑ 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
  9. ↑ cited by authors Herwig Langohr and Patricia Langohr
  10. ↑ Langohr, Herwig; Patricia Langohr (2010). The Rating Agencies and Their Credit Ratings: What They Are, How They Work. Wiley. p. 48. ISBN   9780470714355.
  11. ↑ 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.
  12. ↑ from Altman, Edward I "Measuring Corporate Bond Mortality and Performance" Journal of Finance, (September 1989) pp. 909–22
  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. Archived from the original on 27 July 2013. Retrieved 29 May 2013.
  15. ↑ "DBRS: Short-Term and Long-Term Rating Relationships" (PDF). DBRS. Archived from the original (PDF) on 2011-04-28. Retrieved 2013-06-28.
  16. ↑ "External credit assessment institution source (ECAIs)". European Central Bank. Archived from the original on 3 February 2014. 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.
  18. ↑ Joint Committee of the European Supervisory Authorities. "Amended Mapping of Moody's Investors Service credit assessments under the Standardised Approach" . Retrieved 2019-06-21.
  19. ↑ Joint Committee of the European Supervisory Authorities. "Amended Mapping of Fitch Ratings' credit assessments under the Standardised Approach" . Retrieved 2019-06-21.
  20. ↑ Joint Committee of the European Supervisory Authorities. "Amended Mapping of S&P Global Ratings' credit assessments under the Standardised Approach" . Retrieved 2019-06-21.
  21. 1 2 European Commission, based on a draft from the Joint Committee of the European Supervisory Authorities (7 October 2016). "COMMISSION IMPLEMENTING REGULATION (EU) 2016/1799 of 7 October 2016 laying down implementing technical standards with regard to the mapping of credit assessments of external credit assessment institutions for credit risk in accordance with Articles 136(1) and 136(3) of Regulation (EU) No 575/2013 of the European Parliament and of the Council" . Retrieved 2019-06-21.
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