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| Credit Rating |
What It Is:
In personal finance, the term credit rating commonly refers to a score issued by the Fair Isaac Corporation (a "FICO score"). A person's credit rating indicates how creditworthy he or she is.
In corporate finance, a credit rating is a "grade" assigned to a bond, bond issuer, insurance company, or other entity or security to indicate its riskiness.
How It Works/Example:
Bond rating agencies like Moody's and Standard & Poor's (S&P) provide a service to investors by grading fixed income securities based on current research. The rating system indicates the likelihood that the issuer will default either on interest or capital payments.
- For S&P, the ratings vary from AAA (the most secure) to C.
- For Moody's, the ratings go from Aaa to D which means the issuer is already in default.
Only bonds with a rating of BBB or better are considered 'investment grade'. BBB bonds are considered to be suitable for investment by institutions. Anything below the triple B rating is considered to be junk, or below investment grade. Bond ratings are periodically revised based on recent data.
| Moody's | S&P |
Meaning |
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Investment Grade Bonds |
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| Aaa | AAA | Bonds of the highest quality that offer the lowest degree of investment risk. Issuers are considered to be extremely stable and dependable. |
| Aa1, Aa2, Aa3 | AA+, AA, AA- | Bonds are of high quality by all standards, but carry a slightly greater degree of long-term investment risk. |
| A1, A2, A3 | A+, A, A- | Bonds with many positive investment qualities. |
| Baa1, Baa2, Baa3 | BBB+, BBB, BBB- | Bonds of medium grade quality. Security currently appears sufficient, but may be unreliable over the long term |
| Non Investment Grade Bonds (Junk Bonds) | ||
| Ba1, Ba2, Ba3 | BB+, BB, BB- | Bonds with speculative fundamentals. The security of future payments is only moderate. |
| B1, B2, B3 | B+, B, B- | Bonds that are not considered to be attractive investments. Little assurance of long term payments. |
| Caa1, Caa2, Caa3 | CCC+, CCC, CCC- | Bonds of poor quality. Issuers may be in default or are at risk of being in default. |
| Ca | CC | Bonds of highly speculative features. Often in default. |
| C | C | Lowest rated class of bonds. |
| - | D | In default. |
Why
It Matters:
Credit ratings have huge influence on the price and demand for certain
securities, particularly bonds: The lower the credit rating, the riskier the
investment and the less the investment is worth. Therefore,
lower-grade/higher-risk securities pay higher interest rates to attract buyers.
Low credit ratings are not always bad. They simply mean there is more risk associated with an investment and thus more potential for higher returns. In fact, many income investors actively enhance their returns by investing in lower-grade debt.
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