What it means
When you lend money, you want to know how likely you are to be repaid. Few investors can analyse every issuer in depth, so ratings services do it for them.
They study the borrower's finances, industry, management and debt terms, and then publish a rating on a standard scale. The scales use letters.
The top grades signal very low risk, middle grades signal moderate risk, and lower grades signal high risk and speculative investments. The line between investment grade and speculative grade is especially important because many institutions are restricted to holding only investment-grade debt.
Ratings influence the cost of borrowing. A strongly rated company can raise money at a lower interest rate than a weakly rated one, because investors need less reward for the risk.
A downgrade can raise a firm's borrowing costs, trigger clauses in loan agreements and force some investors to sell. The best-known ratings services are S&P Global Ratings, Moody's and Fitch, which together dominate the market.
They are paid mostly by the issuers they rate, which has raised concerns about conflicts of interest. Regulators in many countries oversee them and require disclosure of methods.
The nuance is that a rating is an opinion about the probability of default, not a guarantee and not advice to buy or sell. Ratings can lag events, and past crises have shown they can be wrong.
Sensible investors treat them as one input alongside their own analysis. Ratings are reviewed over time rather than fixed once.
A service may place a borrower on watch, change its outlook from stable to negative, or move the grade up or down by one or more notches as results and debt levels change. Treasurers therefore track not only the current grade but also the direction in which it is heading.
In practice
Real-world examples.
Example
A manufacturer plans to issue a ten-year bond. Before the sale it meets a ratings service, which assigns an investment-grade rating. The strong rating lets the company borrow at a lower interest rate than it would otherwise have paid.
Example
A pension fund has a rule that it may only hold bonds with a rating above a stated level. When a ratings service downgrades one of its holdings below that level, the fund must sell it. The sale pushes the bond's price down further, which also hurts other holders of the same bond.
Example
A city government wants to finance a new hospital. It seeks a rating before issuing bonds, because without one, many investors would not consider buying them. The rating helps the city price the bonds in line with its financial strength, and a better grade can save the taxpayers meaningful interest over thirty years.
Case study
Seen in the real world.
Eastgate Retail is an illustrative, fictional chain of stores that had borrowed heavily to expand. A ratings service reviewed the company and cut its rating by one notch, citing rising debt compared with earnings.
Within weeks, the interest rate on the company's next loan rose by half a percentage point. On a $50,000,000 loan, that added 50,000,000 x 0.005 = $250,000 a year to the interest bill.
The finance director responded with a plan to cut debt by selling two warehouses and slowing store openings, and the rating was later stabilised. The illustrative lesson is that a rating is not a vanity badge: it translates directly into the price a company pays for money. For a non-specialist, the practical use is simple, because a published rating gives a quick read on how solid a supplier, customer or partner is before a long contract is signed.
Watch out
Common mistakes.
- Treating a high rating as a guarantee that the borrower will never default.
- Assuming all ratings services use the same scale and methods, when they can differ in how they weigh the same facts.
- Ignoring the possibility of a downgrade, which can raise costs and trigger contract clauses.
Questions
People also ask.
Who pays for a rating?
In most cases the issuer of the debt pays, which is why regulators monitor the potential for conflicts of interest. Some investors also pay for independent research as a cross-check.
What is investment grade?
It is the range of ratings that signal a relatively low risk of default, and it matters because many investors can only hold debt in this range. A rating can apply to a whole company, to a single bond or to a country, so the same company can carry different grades on different debts.
Can a company challenge its rating?
It can present additional information to the ratings service and ask for a review, but the final rating is the service's own opinion, and an appeal rarely changes the outcome without new facts such as a debt repayment or an asset sale.
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