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Credit rating

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A credit rating is a formal evaluation of credit risk. It is used for a prospective debtor. A debtor can be an individual or a business. It can also be a large company or a national government. This process helps experts forecast the ability of a debtor to pay back debt. If they cannot pay, it is called a default. Rating agencies use qualitative and quantitative information for this task. This includes data provided by the debtor itself. Analysts also use non-public information to reach their conclusions.

There are two main types of ratings based on time. These are short-term and long-term ratings. A short-term rating covers a time horizon of one year or less. A long-term rating covers any period longer than one year. In the past, institutional investors preferred long-term ratings. Today, short-term ratings are used very commonly. These ratings express the likelihood that a party will default within that specific time.

Agencies use different systems to assign these grades. Most major agencies use letter designations like A, B, or C. Higher grades represent a lower probability of default. Standard & Poor's uses uppercase letters with plus and minus signs. Moody's uses a mix of uppercase, lowercase, and numbers. Some agencies, like DBRS, use words like "high" and "low" instead of symbols. DBRS scales from AAA for excellent to D for poor. A.M. Best uses a different scale from A++ down to S.

Three massive agencies control about 95% of the credit rating business. These are Standard & Poor's, Moody's, and Fitch Ratings. They are so significant that the European Central Bank recognizes them. The bank uses them to determine collateral requirements for borrowing. This helps decide how much banks can borrow against sovereign debt. Other systems like CTRISKS map grades to a one-year probability of default. The European Banking Authority also uses mapping tables for Credit Quality Steps.

Experts also provide sovereign credit ratings for entire nations. This indicates the risk level of a country's investing environment. These ratings consider political risk and economic risk. A survey by Euromoney monitors the stability of 185 sovereign countries. In the fourth quarter of 2019, Switzerland was ranked as the least risky country. It earned an overall score of 88.16. Singapore is also highly stable. It is often the least risky country and holds a AAA rating from all major agencies.

Credit ratings help determine the cost of borrowing through interest rates. This is often measured as a "spread" over riskless US Treasury bonds. A study by Moody's showed how ratings affect cumulative default rates. For bonds with an Aaa rating, the rate was only 0.18% over five years. For a B2 rating, the rate rose to 31.24%. Higher risk leads to higher interest to attract investors. A AAA-rated bond paid only 43 basis points over a Treasury bond. In contrast, a CCC-rated "junk" bond paid over 7% more on average.

These ratings connect to many different global systems. They affect how insurers meet their financial obligations. A.M. Best defines country risk as factors affecting an insurer's ability to pay. Ratings also impact trade credit risk for exporters. They help organize the global economy by managing payment default risk. By predicting risk, these agencies help maintain order in international finance. They allow investors to make informed choices about where to place their capital.

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