What Do Corporate Credit Ratings Mean For Investors?

Every so often, headlines of a credit rating downgrade will be followed by news of a 10 or 20 percent drop in a stock’s share price. While most long-time investors are familiar with the idea that credit rating upgrades are good and downgrades are bad, they are not all familiar with the nuisances of what credit ratings are and what they mean.

Much like a personal credit score, a company’s credit rating reflects how likely the company is to repay its debt. Typically, this debt is takes the form of corporate bonds.

The “big three” credit rating agencies are Moody’s Corporation MCO, S&P Global Inc SPGI and Fitch Ratings. Although each ratings agency has its own unique system, there are parallels.

A full breakdown of the long-term credit ratings of the three agencies is included in the chart below.

Perhaps the most important part of a credit rating for companies and investors is whether or not a company’s debt is rated “investment grade.”

For all three rating agencies, “investment grade” debt is debt rated BBB or higher. If a company’s debt rating falls below BBB, it is considered non-investment grade. You may also have heard non-investment grade bonds referred to as “junk bonds.”

That may seem a bit harsh, but in reality, a downgrade to junk-level can be very bad news for a company. First, that junk label will discourage an entire class of investors who are looking for high-quality bonds.

Second, as credit ratings fall, the interest rates the company has to pay on debt rises. In this respect, a company’s credit rating has a major impact on its overall cost of capital.

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A certain type of high-yield investor seeks out junk bonds to buy because of their relatively high yields. Junk bond ETFs like the iShares iBoxx $ High Yid Corp Bond (ETF) HYG operate on the idea that there is safety in diversification.

On the other hand, investment grade corporate bond ETFs like iShares IBoxx $ Invest Grade Corp Bd Fd LQD contain only corporate bonds rated BBB or higher and are much better choices for risk-averse investors.

Investors who know what corporate credit ratings are, where they come from and what they mean certainly have a leg up when it comes to understanding the financial situation at a particular company. However, it’s important to remember that the ratings agencies themselves are certainly fallible. During the mortgage bubble, for example, many of the mortgage-backed securities (MBS) that ended up completely or nearly worthless were rated AAA by the big three agencies.

Credit ratings are certainly useful in getting a sense of investment risk, but they are only one part of the full picture of a company’s financial health.

Full ratings data available on Benzinga Pro.