A credit rating is given to a company or debt issue after a disinterested third party evaluates the strength of the business or cash flow and rates its ability to pay all of its liabilities.

Third-party institutions such as Standard & Poor’s (S&P), Moody’s, and Fitch will conduct research in order to give investors an idea of how likely a business, bond issue, or insurance company can pay all of its obligations.

Additionally, individual consumers who use credit cards or loans from banks can have a credit score assigned using the applicant’s credit history, which is accessible in national credit databases kept by Equifax, Experian, and TransUnion. Credit ratings, and their ability to be kept in accessible databases, is vital to the financial services and investment industry.

Anyone entering into a contract where debt is involved, such as a bond, or a risk (counter-party risk) is taken on by an insurance company, or making a loan to a consumer, needs to have an idea of how likely that person or entity is to uphold their side of the contract.

Bond buyers know that ratings above BBB are considered Investment Grade, while below that level is considered Junk Bonds, or, more euphemistically, High Yield Bonds. Junk bonds must pay a higher yield than Investment Grade bonds to offer investors an incentive to take on the additional risk of default. This is known as a risk premium.

Similarly, an individual with a low credit score will be charged more interest for a loan than an individual with a higher credit score — this is also a risk premium. Insurance companies are evaluated based on their credit ratings since they take on so many risks and liabilities in the form of insurance contracts.

Bond issuers can improve their ratings by purchasing bond surety insurance from a credit-worthy insurer. The SEC (Securities and Exchange Commission) permits companies like Fitch, Moody’s, and Standard and Poor’s to issue ratings that can be used within the industry for self-regulatory purposes.

In this capacity, they are known as NRSROs, or Nationally Recognized Statistical Ratings Organizations, or, less loquaciously, as Credit Ratings Agencies (CRAs).

What are Bond Ratings?
What is a AAA/Aaa rating?