The Role of Credit Ratings in Markets
Credit Ratings Explained
What are credit ratings and why do they matter? You have come to the right place as we give you a crash course.
Bonds are a debt instrument. Investors want to know the credit worthiness of the issuer they are buying the bond from. In other words, they want to know the likelihood they will get their money back.
A credit rating determines the likelihood of the borrower repaying the loan within the agreement without defaulting. A high credit rating suggests that a borrower is likely to repay the loan without any difficulties, while a poor credit rating suggests that the borrower might struggle or not be able to make due on their payments.
Bond and money market ratings, also known as credit ratings, are quantitative measures of a borrower’s creditworthiness.
Credit ratings can be assigned to “any entity that seeks to borrow money - an individual, a corporation, a state or provincial authority, or a sovereign government.”
Four Rating Agencies
The credit rating industry is dominated by four agencies. The top agencies in order of global market share are Standard and Poor’s (S&P), Moody’s Investor Services, Fitch Group and DBRS Morningstar. Moody’s and S&P hold a global market share of 40% each, while Fitch holds approximately 15% market share.
Outside Moody’s Investors Service Inc. headquarters in New York City, U.S. (Source: Scott Eells / Bloomberg).
Moody’s and S&P are headquartered in New York City, Fitch Group is dual-headquartered in New York City and London, while DBRS Morningstar is based in Toronto. In 1909, Moody’s issued the first publicly available credit ratings for bonds.
The role of rating agencies is to assess the financial strength of companies and government entities. The rating assigned shows the agency’s confidence level that the borrower will honour its debt obligations.
Rating agencies offer third-party opinions from a future perspective about credit risk. Credit ratings from these agencies are essential in the development and functionality of capital markets by providing transparent information to market participants. A substantial amount of due diligence is performed by rating agencies when making opinions on credit ratings.
Credit Rating Scale
Credit rating agencies compare the quality of credit ratings on a scale. Each agency has its own, slightly different definition of credit quality. In general, however, they go from AAA as the highest quality, to C or D, as the lowest quality.
Agencies also have separate ratings for long-term and short-term. In general, one year or under is considered short-term, and anything above that is considered long-term.
Credit rating scale used by the three largest credit rating agencies.
Who Has a Credit Rating?
Sovereign Credit Ratings:
Many countries and states sell their securities on the international market. A high credit rating will help countries attain access to high-value investors. Inversely, a low credit rating will discourage investors from purchasing that country’s bonds or direct investments within the nation.
An example of this was seen in the downgrading of Greece, Portugal and Ireland by S&P to essentially “junk” bonds in 2010 which accelerated the European sovereign debt crisis.
Government of Canada: Canada has a prime, investment grade AAA credit rating from all four rating agencies except for Fitch Ratings, which recently downgraded its rating to an AA+ as of June 2020.
Province of British Columbia: B.C. has one of the highest credit ratings among Canadian provinces and the highest based on Moody’s Investors Service at a Aaa rating. The province’s high credit rating matches a strong balance sheet and the diversity of its economy.
A full list of credit ratings by country from the four aforementioned rating agencies can be found here.
Corporate Credit Ratings:
Canadian Banks: Canadian banks are some of the most highly rated financial institutions in the world. On average, Toronto-Dominion Bank and Royal Bank of Canada have the highest credit ratings amongst Canadian banks. According to Global Finance, the top ten safest banks in North America include six Canadian banks. As of 2022, no Canadian bank holds a credit rating of AAA.
Credit Rating vs. Credit Score:
In simple terms, credit ratings are expressed as letter grades and used for businesses and governments. Credit scores are numbers used for individuals and some small businesses.
Credit scores range from 300 to 850, while credit ratings are produced by credit rating agencies. Credit scores are focused at the consumer level to assist banks in determining the risk premium to be charged on loans. A lower credit score indicates that the loan issued by the bank will have a higher risk premium and will create an increase in the interest charged on the loan.
Importance of Credit Ratings
A credit rating determines whether the borrower will be approved for a loan, but also the interest rate at which the loan will be repaid. Clearly, a high interest rate loan is more difficult to fully pay back.
A borrower’s credit rating plays a role in determining which lenders will provide loans, as some lenders prefer to only work with great credit ratings, while others may tend to take more risk with good or poor credit ratings.
What Impacts Credit Ratings?
These are some of the primary factors that will influence the credit rating of a company or government borrower:
The company’s payment history, including any missed payments or defaults.
The amount they currently owe, and the types of debt they have.
Current cash flows and income.
The market outlook for the company.
Any organizational issues that might prevent timely repayment of debts.
Credit ratings can change over time, for example, the credit rating of the United States government by S&P was adjusted from a AAA rating to AA+ in August 2011. This change resulted in a significant drop in global equity markets because of the impact the U.S. has on the global economy.
The passage of time will also affect credit ratings, as an entity with a short credit history with good credit will not be viewed as favourably as an entity with a long credit history and an equally good credit rating.
Investors were not deterred following S&P’s downgrade of the United States (Source: Bloomberg).
As always, if you have any questions about credit ratings, you can call us at 604-643-0101 or email cashgroup@cgf.com.
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