What is a credit rating and how do they work?

What is a credit rating?

A credit rating assesses the creditworthiness of a company or government, reflecting its ability to meet financial obligations, such as debt repayments. Credit rating agencies assign these ratings to indicate the likelihood of a borrower defaulting on their loans.

The rating is indicated through grades that represent the risk associated with assets like shares or bonds issued by the entity. Changes in credit ratings can impact the market price and perceived risk of these assets, influencing trader decisions and market activity.

How do credit ratings work?

Credit rating agencies analyse factors such as financial statements, debt levels and market conditions to evaluate the financial health of a government or company. They then assign a credit rating that reflects the entity’s ability to meet its financial obligations.

The three major credit rating agencies are Standard & Poor's (S&P), Moody's Investors Service and Fitch Ratings. Agencies that give higher scores when they’re confident that a company or government will repay its debts without issue, and lower scores when they think that a default is more likely.

Here are some ways that credit ratings can impact asset prices:

• Bonds – rating downgrades could cause bond prices to fall and yields to rise, while an upgrade could cause bond prices to increase and yields to decrease.

• Stocks – changes in credit rating might impact risk perception and share prices.

• Derivatives trading – ratings help traders assess risk and develop trading strategies. 

Create an account  Open a demo account

Corporate vs sovereign credit ratings

There are two main types of credit rating that apply to trading, corporate and sovereign. 

Corporate credit ratings assess the creditworthiness of companies, with consideration of financial performance, debt levels, industry conditions and credit history. These ratings can influence the price of shares issued by publicly listed companies.

Sovereign credit ratings evaluate the ability of a government to meet its financial obligations by reviewing economic indicators, political stability, monetary policy, inflation and national debt. These ratings may shift the market price of government bonds.

We can categorise these types based on the timeframe associated with the rating. Shorter-term ratings indicate likelihood of a potential borrower failing to repay its debts in less than a year. Longer-term ratings can extend further in the future.

What are the different ratings?

All of the major credit rating agencies use a letter-based system to grade creditworthiness, with slight variations in their scales. 

Investment grade ratings
 

Investment grade ratings are the highest a borrower can achieve, indicating a strong likelihood of meeting debt obligations and a low risk of default. These ratings are critical because they enable companies and governments to borrow money at favourable terms.

AAA to A- (or A3 with regards to Moody’s) are often considered to be the highest grades while BBB+ to BBB- are known as ‘lower-medium grade’ credit ratings. 

Due to their attractiveness to traders, assets with these ratings don’t need to offer particularly high yields.

Non-investment grade ratings
 

Non-investment grades, often called ‘junk bonds’  imply a greater risk of default compared with investment-grade entities.

BB+ to B- grades may be given to governments or companies facing financial difficulties. While they represent an adequate ability to repay their debts, these entities are vulnerable to adverse economic conditions, which could impact their repayment ability.

CCC+ to CC grades indicate highly speculative assets, typically issued by companies at substantial risk of default, and a C grade implies that a borrower could fail to meet all of its debt obligations at any moment, potentially imminently.

D is the lowest possible credit rating, signifying that the entity is in, or about to enter, administration or bankruptcy, reflecting an inability to meet debt repayments.

What are RD and SD credit ratings?

While D is the lowest grade at Moody’s, there are two ratings that go even lower.

RD, or restricted default, is exclusively used by Fitch Ratings to indicate that a government or company has defaulted on one or more of its financial obligations, while continuing to meet others. The entity is still operational and has not yet entered bankruptcy or liquidation.

SD, or selective default, is used by Standard & Poor’s to show that a company has defaulted on at least one financial obligation. This rating suggests that the decision to default was deliberate, rather than a complete inability to pay.

FAQs