Credit Ratings 101

Credit Ratings 101

In this article I will explain what credit ratings are, what they mean, and their implication on a company’s financials. This will be the prerequisite to a future article where I will walk you through a credit analysis. A disclaimer, I am not a financial advisor and my comments should never be taken as financial advice. Investments come with risk, so always do your research and analysis beforehand!

Credit ratings are a combination of letters (sometimes numbers too) that reflect how risky a company is to lend money to and thus how likely a company is to pay back its debt. There are three large independent credit rating agencies that give companies credit ratings. They are Moody’s, Standard and Poors (S&P), as well as Fitch. S&P and Fitch have a ranking scale of AAA-D, and both use pluses and minuses. Moody’s ranks on a scale of Aaa to C and uses numbers in place of the third letter, for example Aa1 instead of S&P’s AA+.

The following is according to Bezinga. The highest rating AAA/AAa is described as prime, AA/Aa is described as high grade, A is described as upper-medium grade, and BBB/Bbb is described as lower-medium grade. All of these ratings AAA-BBB are “investment grade”. BB-D are “speculative-grade” also known as “junk bonds” or high yield bonds. The distinction is important because certain funds are only allowed to hold investment grade bonds. A surprise downgrade can see bond prices drop as these funds are forced to sell.

BB are described as non-investment grade speculative, and B are described as highly speculative. Below B rating many rating agencies differ in conventions, but the descriptions of CCC, CC, and C vary from substantial risk, extremely speculative, default imminent with little possibility of recovery and in default. S&P and Fitch have their “d” ratings signify a company is in default.

This was a lot of conventions, but it is can be helpful to know. Credit ratings can be a good first indication of a company’s financial health. You can see a company’s credit rating in their 10-K annual report, or 10-Q. It is important to acknowledge that credit ratings agencies have been wrong in very obvious ways before, like the financial crisis. While it is smart to acknowledge this and not make investment decisions based on credit ratings, there is very useful information that can be taken from them. For example, if a company is rated between CC/Ca-D (between default imminent with little possibility of recovery and in default), you may want to read about the company’s bankruptcy or potential bankruptcy. Furthermore with the previously mentioned range, it is important to understand the risks of trading a stock in bankruptcy or near bankruptcy (check out my article on bankruptcy if you have any questions).

An central point from that article is that companies in or approaching bankruptcy often have stock that is at a high risk of being worthless. Credit ratings can alert anyone to this potential risk. This indication can also go the opposite way, AAA rated companies are seen by credit rating agencies as extremely likely to pay back their debt. Thus, unlikely to enter bankruptcy. One consideration is that safer companies are less risky, and in the world of investing you are compensated for risk. So in theory, high risk equals high reward (if you actually get paid). In practice this does not always hold true. Stay tuned for an article about this diving into the sharpe ratio and the efficient markets hypothesis.

Now with a background on credit ratings, we can discuss credit analysis, or gauging if a company can handle more debt, and if so how much. Follow me on Invstr @robbieb for market updates and opinions.

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