Credit rating

Lore & Background

A credit rating is an assessment of the credit risk of a potential borrower, which could be an individual, a business, a company, or a government. It involves forecasting the borrower’s ability to repay a debt or the likelihood of default. This evaluation is made by a credit rating agency based on both qualitative and quantitative information, including data provided by the borrower and other non-public details gathered by the agency’s analysts.

Credit reporting, also known as a credit score, is a specific type of credit rating that gives a numerical evaluation of an individual’s creditworthiness, performed by a credit bureau or consumer credit reporting agency. A sovereign credit rating applies to a national government and reflects the risk level of a country’s investment environment, factoring in political risk; investors use it when deciding where to invest. Euromoney’s biannual country risk index tracks the political and economic stability of 185 sovereign nations, and since 2017, Singapore has often been ranked the least risky country, being one of the few worldwide and the only one in Asia to hold AAA sovereign credit ratings from all major agencies. Ratings are divided into short-term and long-term categories: short-term covers a time horizon of one year or less, while long-term covers anything beyond that.

Corporate credit ratings are assigned by agencies like Standard & Poor’s, Moody’s, and Fitch Ratings, using letter grades such as A, B, or C, where higher grades indicate a lower chance of default. Different agencies use variations of alphabetical combinations, sometimes with plus or minus signs or numbers. The European Central Bank recognizes only four rating agencies—S&P, Moody’s, Fitch, and DBRS—for setting collateral requirements when banks borrow from the central bank, applying the highest rating among them to determine haircuts and collateral terms.

Reader's Guide

A credit rating expresses the likelihood that the rated party will go into default within a given time horizon. For sovereign credit ratings, investors use them to assess the risk level of a country's investing environment. For corporate credit ratings, agencies do not attach a hard number of probability of default to each grade, preferring descriptive definitions. However, studies have estimated average risk and reward by rating.

For example, one Moody's study found that over a 5-year time horizon, bonds rated Aaa had a cumulative default rate of 0.18%, while B2-rated bonds had 31.24%. Another study in Journal of Finance calculated that from 1973–89, a AAA-rated bond paid 43 basis points over a US Treasury bond, while a CCC-rated junk bond paid over 7% (724 basis points) more. Under the EU Credit Rating Agency Regulation, the European Banking Authority has developed mapping tables that map ratings to Credit Quality Steps and to benchmark default rates.

Did You Know?

• The ECB uses a first-best rule among S&P, Moody's, Fitch and DBRS to determine haircuts and collateral requirements for borrowing.