Overview of Credit Ratings
12 Pages Posted: 21 Oct 2008 Last revised: 10 Nov 2021
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Overview of Credit Ratings
Abstract
This note is a brief summary of how credit-rating agencies do their job. It includes historical information on rates and capital spreads. The note serves as useful supplementary reading, for students encountering, for the first time, bonds in a capital-structure case, a capital-markets case, or a cost-of-capital case. The note is designed for undergraduate and executive audiences.
Excerpt
UVA-F-1413
Rev. Apr. 29, 2019
Overview of Credit Ratings
As the number and complexity of financial instruments in the global financial markets have grown, credit ratings have taken on heightened importance in helping individual and institutional investors make better-informed investment decisions. Credit-rating agencies are often regarded as the gatekeepers of the capital markets because of the impact of their opinions on the structuring and pricing of financial products.
What Is a Credit Rating?
A credit rating is an opinion of the general creditworthiness of either an issuer or one of the specific issues made by the issuer. The rating is based on whatever risk factors the rating agency believes are relevant to the likelihood that the issuer will honor the terms of a financial contract. An example of an issuer rating is the rating of a company (e.g., IBM), an organization (e.g., Fannie Mae), or a sovereign country (e.g., Brazil). An example of an issue rating is a rating of a specific instrument of an issuer, such as Bell South's bond with a 6.875% coupon and maturity of 2031. The risk and, therefore, the rating of an issue will depend on how it is structured in terms of its seniority relative to other issues in the capital structure and in terms of its collateral (i.e., assets pledged as security). Because of these structural factors, an issue may receive a different rating than the issuer. While ratings remain primarily focused on debt and other fixed-income instruments, the spectrum of rated instruments has grown. Exhibit1 provides a summary of the various types of rated securities.
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Keywords: financial institutions, risk analysis
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