Understanding Investment Credit Ratings

By on October 19, 2018

Despite their ubiquity in the financial markets, credit ratings are often misunderstood. Most people are aware that US federal government’s credit rating was once downgraded from an outstanding AAA to a good AA+, but how many people actually understand what credit ratings are all about?

Confusion about what credit ratings are, and the role they play in the financial system, has sometimes led to their misuse and prevented them from fulfilling their true role, which is to close the information gap between lenders and borrowers by providing independent opinions of creditworthiness.

What is an Investment Credit Rating?

One way to describe the role of credit ratings is in terms of how information, or the lack thereof, affects the actions of participants in the financial markets. Enter credit ratings. These ratings can provide investors (lenders) with a standard of measure to better distinguish the creditworthiness of company (borrowers) stocks, securities, bonds, etc. and help them build confidence in their choice.

Just as your credit score is measuring your personal risk for paying bills, investment credit ratings are predictions about credit risk in the market for a particular company. Ratings are provided by independent organizations commonly called ‘credit rating agencies’, which specialize in evaluating credit risk. Each agency applies its own methodology in measuring creditworthiness and uses a specific rating scale to express its opinions.

For instance, Standard & Poor’s (S&P 500) credit ratings express the agency’s opinion about the ability and willingness of a stock issuer, such as a corporation or state or city government, to meet its short-term and long-term debt obligations in full and on time. Other credit ratings might focus on the credit quality of a particular investment vehicle — such as a corporate stock, a municipal bond or a mortgage-backed security — and the relative likelihood of default.

Why Use Credit Ratings

By using ratings as an independent, unbiased measure of comparison, the investor may be able to more accurately map potential returns based on the true riskiness of the stock issuer. The overall result should be a superior allocation of limited capital to productive uses.

Reading Credit Ratings

Credit ratings are expressed as letter grades that range from ‘AAA’ at the top to ‘D’ at the bottom, to communicate the agency’s opinion of relative level of credit risk. A rating that indicates that a municipal or corporate bond has a relatively low risk of default.

Low Risk/High Credit Rating = quality investment: AAA’ and ‘AA’
Medium Credit Rating = investment grade: ‘A’ and ‘BBB’
High Risk/Low Credit Rating = ‘junk bond’ status: ‘BB’, ‘B’ and below to ‘D’

An agency downgrade of a company’s rating one-step from ‘BBB’ to ‘BB’, indicates its debt is reclassified from investment grade to ‘junk bond’ status. The repercussions of such a downgrade can be highly problematic for the issuer and can also adversely affect bond prices for investors. Risk-averse fund investors would be smart to monitor a bond fund’s portfolio credit rating.

**Note: Government bonds and treasuries are not subject to credit quality ratings as they are considered to be of the very highest credit quality. In the case of municipal and corporate bond funds, company reports and independent investment research companies will submit an assessment of “average credit quality” for the fund’s portfolio as a whole, which investors will want to use as a guide for creditworthiness.

Benefits of Credit Rating to Investors

Credit ratings help investors make informed decisions about the credibility of the issuer company, and the risk factor attached to a particular investment. By depending on a trusted, professional rating agency, investors are free from wasting time and effort to collect and analyse mounds of data and financial information about the credit standing of the issuer company before having the confidence to make a decision.

The higher the rating, the more investors are willing to purchase or keep these investment vehicles until the next rating or maturity. If the instrument is downgraded, then the investor may decide to sell it.

3 Ways Credit Ratings Help Investors Make Informed Decisions

  1. A standardized measure for the financial discipline of a company
  2. Risk can be compared across various instrument choices
  3. Allow potential investors to easily assess the safety of their money

Benefits of Credit Rating to Company

Credit ratings can be a useful guide for companies as well. When used as a gauge for company performance, these rating can boost the confidence and trust of the investors or spur efforts to improve the corporate image in the marketplace. In addition, a good credit rating can develop confidence in the minds of important non-investors: customers, dealers, suppliers, etc.

Companies with high credit ratings may be able to secure funds at a lower cost and reduce the need to spend heavily on advertising to attract investors. With a good rating they could attract lots of investors by offering low interest rates on fixed deposits, debentures and other debt securities. A high rating also opens up companies to a wider audience for borrowing, such as financial institutions, banks, investment companies.

Just as with personal credit scores, good credit ratings can open doors to financial opportunities for a company to grow and expand. They inspire investor confidence and ease pathways to financing.

Learn More About The Credit Rating for Your Investments

Credit ratings are simply one useful tool to measure risk for earning a return from a particular investment. They are the key to demonstrating the creditworthiness of a market entity.

Review your portfolio assets to assess any unforeseen risks. Speak with a trusted financial advisor or stockbroker to help you research and list the credit ratings of each stocks, bonds or security in your portfolio, and make adjustments based on your risk tolerance. If you already use credit ratings to measure risk in your portfolio, speak with your financial advisor or stockbroker for news on changes to any holdings credit rating or potential, low risk investments to add to your portfolio.

Managing risk to the returns and growth of your portfolio will be the work of a lifetime. Learn more about using investment credit ratings to measure risk so you can build confidence in the investment choices you make for the future.

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About Kendrick Lee

Senior writer and business columnist for FSN - Successful businesses, large or small, will lend to successful owners, employees, local communities and markets for continued economic growth. Since there are so many risks, finances and procedures to consider when running a business, Kendrick is dedicated to sharing business tips, strategies and ideas in the public sphere. Find Kendrick on !

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