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CREDIT RATING SYSTEMS
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- What are credit ratings: Credit ratings are opinions about credit risk. The Rating Agency gives an opinion about the ability and willingness of an issuer, such as a corporation or state or city government, to meet its financial obligations in full and on time.
- What do they tell: Credit ratings inform the credit quality of an individual debt issue, such as a corporate or municipal bond, and the relative likelihood that the issue may default.
- Who does these: Ratings are provided by credit rating agencies which specialize in evaluating credit risk.
- Global and regional: In addition to international credit rating agencies, such as Standard & Poor’s Ratings Services, there are regional and niche rating agencies that tend to specialize in a region or industry.
- Methods used: Each agency applies its own methodology in measuring creditworthiness and uses a specific rating scale to publish its ratings opinions. Typically, ratings are expressed as letter grades that range, for example, from ‘AAA’ to ‘D’ to communicate the agency’s opinion of relative level of credit risk.
- No guarantee: While the forward looking opinions of rating agencies can be of use to investors and market participants who are making long- or short-term investment and business decisions, credit ratings are not a guarantee that an investment will pay out or that it will not default.
- Why ratings are useful for corporates and governments
- Whom it helps: Credit ratings enable corporations and governments to raise money in the capital markets
- Borrowing money not from banks: Instead of taking a loan from a bank, these entities sometimes borrow money directly from investors by issuing bonds or notes
- Investor expectations: Investors purchase these debt securities, such as municipal bonds, expecting to receive interest plus the return of their principal, either when the bond matures or as periodic payments
- An aid in decision-making: Credit ratings helps the process of issuing and purchasing bonds and other debt issues by providing an efficient, widely recognized, and long-standing measure of relative credit risk
- A wide range of ratings: Credit ratings are assigned to issuers and debt securities as well as bank loans, and investors use the ratings as a screening device to match the potential investment with their internal guidelines
- Investors use credit ratings to help assess credit risk and to compare different issuers and debt issues when making investment decisions
- Individual investors may use credit ratings in evaluating the purchase of a municipal or corporate bond from a risk tolerance perspective
- Institutional investors (mutual funds, pension funds, banks, and insurance companies) often use credit ratings to supplement their own credit analysis of specific debt issues. They use credit ratings to establish thresholds for credit risk and investment guidelines.
- Investment bankers help to facilitate the flow of capital from investors to issuers.
- They may use credit ratings to benchmark the relative credit risk of different debt issues, as well as to set the initial pricing for individual debt issues they structure and to help determine the interest rate these issues will pay.
- Investment bankers may also serve as arrangers of debt issues.
- Issuers (corporations, financial institutions, national governments, states, cities and municipalities) use credit ratings to provide independent views of their creditworthiness and the credit quality of their debt issues
- Issuers use credit ratings to help communicate the relative credit quality of debt issues, thereby expanding the universe of investors
- Ratings help them anticipate the interest rate to be offered on their new debt issues
- The more creditworthy an issuer or an issue is, the lower the interest rate the issuer would have to pay to attract investors
- Standard & Poor’s credit rating symbols provide a simple and efficient way to communicate creditworthiness and credit quality.
- Investment- and speculative-grade debt
- The term “investment-grade” historically referred to bonds and other debt securities that bank regulators and market participants viewed as suitable investments for financial
- institutions. It describes issuers and issues with relatively high levels of creditworthiness and credit quality.
- In contrast, the term “non-investment-grade,” or “speculative-grade” refers to debt securities where the issuer currently has the ability to repay but faces significant uncertainties, such as adverse business or financial circumstances that could affect credit risk.
- In Standard & Poor’s long-term rating scale, issuers and debt issues that receive a rating of ‘BBB-’ or above are generally considered by regulators and market participants to be “investment grade,” while those that receive a rating lower than ‘BBB-’ are generally considered to be “speculative-grade.”
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