Credit Rating – What it is and its importance in investing

Credit rating determines the creditworthiness of a company and governments. Specialised credit rating agencies evaluate creditworthiness on basis of several factors to determine whether or not the investor is at financial risk. 

What is Credit Rating? 

Credit rating is a score based on a comprehensive report compiled by credit rating agencies to evaluate the debtor’s ability to repay debt. It also considers their current and expected financial position.  

Credit rating agencies use credit ratings to determine the terms of a loan, including interest rates. A high credit rating shows reliability; it shows that the credit rating agency considers the debt a low risk.  

Types of Credit Rating 

Different credit rating companies assign different kind of letter-based grades. The highest rating is AAA or Aaa, while a rating of C or D is the lowest. Agencies might further divide these ratings by assigning + or – or adding numbers from 1–3. For example, S&P assigns -AA, and Moody’s might use Baa1.  

Two distinct categories of ratings are either investment speculative grade. 

Investment Grade:

This indicates that the risk of the investment is low and that the borrower is likely to fulfil the loan's repayment requirements. The ratings between BBB to AAA are considered investment grade.  

Non-Investable Grade:

Non-investment or speculative-grade debt has a credit rating of BB or lower. These instruments are also referred to as "junk bonds," which implies that they defaulted or are about to default. 

Users of Credit Ratings 

Now, what is the importance of credit rating in respect to the users? A higher credit rating of bond may indicate that it is a secured bond and a lower credit rating may indicate an unsecured bond.  

Credit rating can be of great significance to the following users: 

Borrowers:

Credit ratings are important for borrowers because they can affect the terms of a loan, including the interest rate and other fees. Borrowers with high credit ratings are more likely to be able to obtain credit on favorable terms, while borrowers with low credit ratings may be charged higher interest rates or may have difficulty obtaining credit at all. 

Investors:

Credit ratings are important for investors because they can help assess the risk associated with investing in a particular company or government bond. Investors are generally more likely to invest in companies or governments with high credit ratings because they are viewed as less risky. 

Lenders:

Credit ratings are important for lenders because they help determine the risk associated with lending money to a particular borrower. Lenders are generally more likely to lend to borrowers with high credit ratings because they are viewed as less risky. 

Is Credit Rating the same as Credit Score? 

Credit rating and credit score are often considered interchangeable; however, they are not the same. 

Credit rating is a rating given to financial instruments and organizations by credit rating agencies that showcase their creditworthiness. 

Whereas, an individual’s creditworthiness is measured by a number called a credit score, typically from 300 to 900. Credit bureaus use this number to decide whether to grant an individual credit in the form of loans or credit cards. 

What factors go into determining a credit rating 

Now that you know the credit rating definition, we can move on to the factors that determine the credit rating. Credit ratings for businesses and instruments can be affected by a variety of external events, such as: 

Profit and loss statements, balance sheets, and cash flow statements 

• A record of credit extended and received  

• A record of previous indebtedness 

• Past due amounts  

• Balance sheets 

• The extent and nature of existing debt 

But what exactly is the significance of credit rating? A credit rating is one way to evaluate a company's or financial instrument’s fitness to take on debt. Credit rating firms vetted by the government give companies and financial instrument’s an alphabetical grade based on their financial health and propensity to repay loans. 

Investors use credit ratings to determine whether to grant loans or invest in a business. Thus, a strong rating is crucial for attracting capital, securing lower interest rates, and motivating more responsible bookkeeping practices. 

Conclusion 

Credit rating meaning is that it implies the creditworthiness of an organization or government. They show how likely a borrower will be able to make payments on time. A low credit score can cause a borrower to pay more interest on their loans, which can lead to more significant financial problems in the long run. 

FAQs 

Q. Does a AAA credit rating mean I'll never lose my money? 

AAA (or its equivalent) is the safest rating possible. Ratings are based on probabilities, so there is always a chance of default, no matter how small. We must remember that DHFL, which used to sell bonds with a AAA rating, went bankrupt. 

Q. If I buy an NCD with an AA rating, will I lose my money? 

An NCD with an AA rating is likelier to go wrong than an AAA rating. Whether or not that risk will come true depends on how the issuer does in the future and can't be known in advance. The rating agency is supposed to keep an eye on the company's finances to see if anything changes. Investors in high-yield bonds are expected to:  

Keep an eye on the credit ratings of the bonds in their portfolio  

Be able to recover if a bond is downgraded. 

So, weighing the chance of default against the possibility of making more money is essential. 

Q. Does having a Sovereign credit rating mean I will never lose my money? 

Sovereign ratings are given to the government's bonds, which are called gilt. There is no credit risk for an investor in the same country because the government controls the money supply and can print enough money to pay the interest and the principal. Since printing more money causes inflation, the value of the money you get back will be less.