Credit rating is a forward-looking opinion about credit risk and an assessment of the ability and willingness of an issuer to meet its financial obligations in full and on time. Ratings are provided by institutions, commonly known as credit rating agencies, which specialize in evaluating credit risk.
The main task of a credit rating agency is to provide analysis and opinion about the creditworthiness of companies (corporate rating) and states (sovereign rating). In addition, there are municipality ratings, project ratings, financial strength ratings for banks, etc. Rating agencies also provide opinion on structured financial products. The three leading rating agencies in the financial market are: Standard&Poor's (S&P), Moody’s Investors Service (Moody’s) and Fitch Ratings (Fitch).
S&P, Moody’s and Fitch issue two types of sovereign ratings: issuer ratings and sovereign debt ratings. These two ratings are in most cases the same until the point of default, when the sovereign issuer may select which debt securities it will continue to service (SD – selective default). S&P establishes sovereign government ratings based on a comprehensive qualitative and quantitative analysis, which includes assessment of:
- institutional effectiveness and political risks,
- economic structure and growth prospects,
- external liquidity,
- fiscal performance and flexibility, and changes in public debt burden, and
- monetary policy efficiency and credibility.
Similar methodology based on analysis of macroeconomic and political factors, and internal and external environment of a country is used by Fitch.
Both agencies express ratings as letter grades (A, B, C, D) where “AAA” is regarded as the best and “D” as the worst rating. Ratings from “AA” to “CCC” may be modified by the addition of a plus (+) or minus (–) sign to indicate their relative positive within the main rating categories. Rating agencies also provide outlooks that indicate the potential direction of rating in the future. The outlook may be positive, negative, stable and developing. Positive outlook means that a rating may be raised. A negative means that a rating may be lowered and stable means that it is not likely to change. Developing outlook, assigned rarely, suggests a change in rating in the coming 1–3 year period.
As investors and issuers keep a close eye on ratings, credit rating agencies have a significant impact on financial markets. When making investment decisions, investors analyse the ratings of financial instruments and the level of risk associated with those instruments that they find acceptable. Issuer or bond rating affects the issuer’s cost of borrowing. Credit rating of a country affects the credit ratings of other issuers headquartered in the country. Also, investment criteria are often connected with the minimum credit rating a security and/or its issuer must have.