Ratings in Finance: Definition, How They Work, and Types
A rating is an assessment of the creditworthiness or investment quality of a security or issuer. Analysts issue ratings on stocks (e.g., buy, hold, sell) while credit rating agencies assign grades to bonds and issuers that indicate the likelihood of timely repayment and default risk. The three major global bond rating agencies are Standard & Poor’s (S&P), Moody’s Investors Service, and Fitch Ratings.
Key points
- Ratings signal the level of credit risk or investment opportunity.
- Stock ratings typically come from buy‑side or sell‑side analysts and reflect an opinion about future performance.
- Bond ratings come from agencies that evaluate an issuer’s ability to repay principal and interest; they are often interpreted as measures of default probability.
- Higher-rated borrowers pay lower interest; downgrades usually raise borrowing costs and can trigger market or contractual consequences.
How ratings are assigned
- Stock ratings:
- Buy‑side analysts research securities to inform portfolio managers.
- Sell‑side analysts publish research and recommendations for clients and the market.
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Common labels are “buy,” “hold,” and “sell,” though firms use different terminology (e.g., overweight/equal-weight/underweight; outperform/neutral/underperform). Time horizons implied by these ratings can vary (often 12 months or more).
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Bond ratings:
- Credit rating agencies evaluate an issuer’s financial fundamentals, debt structure, cash flows, industry risk, and governance to estimate its ability to meet obligations.
- Ratings reflect both probability of default and factors such as payment priority and credit stability.
Major rating agencies and scales
- S&P, Moody’s, and Fitch each use alphanumeric scales. For investment‑grade ratings, the common tiers are:
- Moody’s: Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3
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S&P / Fitch equivalents: AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-
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Below these levels are speculative (non‑investment‑grade) ratings, which indicate higher credit risk and typically require higher yields to attract investors.
Investment‑grade vs. speculative
- Investment‑grade: Generally BBB‑ (S&P/Fitch) or Baa3 (Moody’s) and above. Indicates a relatively low risk of default.
- Speculative (high yield): Ratings below BBB‑/Baa3. These issuers carry greater default risk and must offer higher interest rates to lenders.
Effects of rating changes
- Downgrade consequences:
- Higher borrowing costs as lenders demand greater compensation for risk.
- Market reactions that can reduce bond prices and increase yields.
- Potential covenant triggers in contracts or investment mandates that restrict holdings to certain rating levels, forcing portfolio changes.
- Upgrade consequences:
- Lower interest costs and improved access to capital.
Example
Rating agencies may differ in judgment. For instance, one agency might downgrade a sovereign issuer citing governance or fiscal concerns while others maintain their ratings, reflecting differences in methodology or emphasis.
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Bottom line
Ratings are a concise signal of creditworthiness and investment quality. Investors should use them as one input among many—combining ratings with independent research on fundamentals, market conditions, and investment objectives—to make informed decisions.