What is a Credit Rating?
A credit rating defines the financial strength of a borrower and helps the investor determine the likelihood that the bond issuer will pay coupon payments in a timely fashion and more importantly the initial investment at maturity. There are two major credit rating agencies; they are Standard & Poors and Moody. They both conduct extensive research on the bond issuer before assigning a credit rating to them. The bond rating will affect the interest rate that the issuer will need to pay investors; the stronger the credit rating, the lower the interest expense for the issuer.
Each of the credit rating agencies rate debt securities with a slightly different ratings scale. Below, you will see what each of these agencies considers investment grade and non-investment grade securities. Lower credit ratings are not necessarily bad. In fact, many investors invest in lower grade securities to receive higher yields. Due diligence must always be done when investing in any bond, especially lower grade ones which are not investment grade.
Credit ratings agencies have been criticized many times for not reacting fast enough to upgrade or more importantly, downgrade an issuers rating. This was especially the case in 2001 and 2002 when many firms went bankrupt; i.e. Enron and WorldCom. In fact, Enron's credit rating was still investment grade a couple days before they went bankrupt!