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What is Credit Rating: meaning and why it’s so important

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Rating (def.) is a synthetic evalutation made by an external independent subject, on the ability and will of a borrower, to face the payment of the capital and interests, related to an emission of debt securities, placed or to be placed, as stated in the contractual obligation.

To be more simple it consists of an alphanumerical symbol that can be easily understood and interpreted by anyone, and it’s useful because with just a letter or a number you can compare different emission with ease.

But probably you are wondering why rating and rating agencies wear such an important role in markets, and why their decision can influence investors so much.

That’s simple.. Rating is a very important cognitive element in determination of  the interest rate payed by the borrower. The interest rate is in fact composed by 2 elements:

  • the benchmark (fixed): that is the distinctive rate for securities with the same duration and structure, and express the needs of units in deficit (borrowers).
  • spread (variable): that express the needs of units in surplus (investors), and changes based on the perception of risk of the issuer.
So, the lower the rating is the higher is the spread the issuer must pay to the investors.
Rating is also useful because it determines if a security is of investment grade or non investment grade (speculative), and this distinction is important too because some subjects, for example pension funds, cannot invest in a financial instrument that’s not of investment grade.
For a slightly clear view of this distinction check the table below.
"Rating Score Table"