I read a funny conversation on Twitter the other day: would you rather have £1,000,000 or a perfect credit rating?
Before I start, you don’t have to ask me twice – I’m taking the £1M, buying a pint and burger from the airport, and booking a one-way ticket out of Birmingham.
What made me laugh was the replies from people saying that they would prefer to take a perfect credit score.
I just thought to myself – pay for everything in cash – you don’t need credit!
Also, why are these people choosing perfect credit over a life-changing sum of money?
Am I missing something?
Then I realised no I’m not – but it was a nice segue into my first question.
What are credit ratings?
In short, credit ratings assess how financially responsible a borrower is.
A credit rating can affect anyone borrowing money – an individual, a corporation, even a sovereign government.
They are forward-looking opinions, meaning they will consider one’s history of borrowing as well as their ability to pay off debt.
Are they important?
Even though I downplayed them earlier, credit ratings are of course important.
A credit rating not only typically helps determine if a borrower will be approved for a loan, but it also helps determine the interest rate at which the loan will be repaid.
Who decides who has a good credit rating?
This depends on who is borrowing money.
If it’s an individual, this will affect individual credit scores and it is scored by Experian, Equifax and TransUnion to name a few.
For companies and governments, rating agencies such as Moody’s, S&P, and Fitch are arguably the most notable.
What is a good credit rating?
Again, this varies for each rating agency but by rule of thumb they all have similar intentions.
For example, having a high credit rating indicates that you are very likely to pay back the debt in full without any problems.
A poor credit rating means that the borrower is less likely to pay back the loan because they have had struggles to do so in the past and could show similar behaviours should they want to borrow again.
It could also mean that they do not have a credit history, for example, they are new to the country or are too young to have built up a credit history.
Okay so, what are the differences between each rating agency?
Well, to give you a quick summary:
Moody’s were the first to make credit ratings for bonds at the start of the 20th Century.
According to Moody’s, creditworthiness is indicated by nine symbols:
Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C.
They are further divided using numerical modifiers as 1, 2 and 3.
For example, A1 > A2 > A3.
Fitch introduced the AAA – D rating system.
AAA is the best; D is the worst (default).
Each band has a triple (AAA), double (AA) and single (A) grade, with the triple grade being the highest.
For instance, AAA > AA > A.
They can also include plus (+) and minus (-) signs which show relative standing within a category – they do not suggest likely upgrades (Rising Stars) and downgrades (Fallen Angels) which we will discuss in a later blog.
S&P Global is best known for stock market indexes such as the S&P 500, a useful tool used by investors to analyse decision-making and the economical state in the US.
The credit rating system of S&P is based on the following order:
AAA+, BBB+, CCC+, D.
For example, AA+ > BB+ > CC+.
Bonds are rated on this scale to assess how comfortably a company can service their debts
Are there bands within the rating system?
Good question – yes.
Investment Grade companies are usually large and stable companies which operate globally.
They are rated AAA to BBB- and generate a lot of cash so they can easily pay off their debts.
Investment Grade companies currently include Glaxosmithkline, HSBC and Unilever.
High Yield companies are also often large established names currently such as Iceland, Aston Martin and The AA.
They are rated BB to D and as the name suggests, they have the highest yield (investment return).
This is because they are perceived as less creditworthy than Investment Grade companies.
Using the Banks & Financials Industry as an example, namely HSBC, have a look at their credit rating below:
Compare that to Flora Food Groups in the Consumer & Food Industry and you can see the difference:
What is the difference between the two?
As I mentioned earlier, credit ratings also affect the interest rate that is charged by lenders.
Traditionally, the higher the chance of default, the higher the interest rate, the lower the credit rating.
Therefore, investing in an Investment Grade company (which has a comparatively lower chance of default) is viewed as a less risky investment opportunity so you would expect lower returns.
Conversely, High Yield companies have worse credit ratings and so you can generally expect higher returns.
How is creditworthiness calculated?
Creditworthiness can be framed using the “5 C’s”:
Capacity – can a borrower’s cash flow support their required repayments?
Capital – can a borrower raise capital that will support their ability to repay?
Collateral – can a borrower pledge an asset against the borrowing? Its purpose is to improve recovery prospects in the event of default.
Character – the borrower’s attitude toward debt – do they always borrow more than they should? Do they use the proceeds well? Have they defaulted previously?
Conditions – how much existing debt does the borrower have outstanding? What interest rates does it pay on its debt?
All this information is collated to produce a credit rating.
So that’s credit ratings!
Hopefully, you have learnt what makes a good credit rating and you can start to make small changes to your lifestyle to achieve this.
All this information is accessible on the WiseAlpha Bond Academy.
As part of our efforts to educate our audience on bonds, WiseAlpha looks forward to educating you further on bond security and what causes bond prices to move in our upcoming blogs.