‘How do credit ratings work?’ can be the question that someone who has never had any experiences in the financial industry or can be a question that is asked by someone who has been denied credit because of a poor rating. Credit ratings are given by third party agencies that collect data on individuals and compile the data into a standardized credit score. The score is a reflection of the historical financial reliability of the debtor and shows how likely he would be to repay a current loan.
An individual new to the market for investing may ask what the ratings mean when assigned to businesses, stocks, and bonds. These ratings can also be applied to issuers of debt and used by the industry to identify changes in the market. The ratings are purchased by debt issuers and are used to promote the sale of securities by the issuer. As the market conditions change the ratings change to reflect the ability of the issuer to pay.
In the individual ratings industry there are three major reporting bureaus. They are called Transunion, Experian, and Equifax. In the public sector the major rating agencies are Standard & Poor, and Fitch and Moody Investment Survey. In the public offering issuers have two ratings. One of these ratings is based on the ability to pay or to cover the debt. This means their ability to pay off the principal and interest of the loan.
Each of these agencies has their own ratings system used to rate securities. The class of the asset will affect the rating. Municipal bonds are an asset class that has a very low rate of default and have an A rating. This can be compared to the AA rating given a corporate bond. When comparing ratings you must compare only those in the same asset class. The ratings can range from those that are low, near default and those that are of a higher quality.
The Moody agency has the following rating scale: Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C. Fitch and S&P use AAA, AA, A, BBB, BB, B, CCC, CC, C, and D. Occasionally a plus or minus sign is used to identify quality of the debt. When an investor is reviewing the scale, any rating above Baa is considered a good investment. If the rating is below Baa the investment is speculative.
We have covered the ratings of debt issuers. Rating agencies also rate countries, not for profit companies, equity in companies, and new finance structures. These agencies also send out bulletins to notify investors about business conditions that may affect bond holders. They also post changes in regulations that can affect these stock and bond holders. Alerts often come out prior to new ratings. Credit rating agencies only deal with institutional ratings for public and private issuers. Your question, ‘How do credit ratings work?’ has been answered and you have information to help you formulate your investment strategies.