A credit rating is an assessment by an independent agency of a company’s ability to pay its financial commitments when they are due. Such financial commitments may include interest payments, dividends on preferred stock and the repayment of principal. Credit ratings provide an evaluation of credit risk and they do not directly address other types of risk.

Credit ratings serve an important purpose for both investors and companies. They enhance investor confidence by providing a reliable independent evaluation of investment risk. A healthy credit rating can help a company obtain financing at lower costs and increase its overall access to financial markets.

The major credit agencies are registered as Nationally Recognized Statistical Rating Organizations (NRSROs) and are subject to regulation by the U.S. Securities and Exchange Commission (SEC). In the United States, the three most prominent credit rating agencies are Moody’s, S&P Global Ratings and Fitch Ratings. The Office of Credit Ratings (OCR), which was established by the Dodd-Frank Act, oversees credit rating agencies. The OCR conducts regular examinations of registered NRSROs to ensure compliance with SEC rules and regulations.

Credit ratings indicate whether a company’s debt is considered investment grade or non-investment grade. Non-investment grade debt, also known as high-yield debt, has a higher risk of default. If a company is assigned a rating of AAA to BBB (S&P and Fitch) or Aaa to Baa (Moody’s), it is considered investment grade. If a company is assigned a rating of BB (S&P and Fitch) or Ba (Moody’s) or lower, that indicates that the company’s debt obligations have higher speculative characteristics. Non-investment grade debt is also referred to as high-yield debt or junk bonds.

In addition to the credit rating categories, an outlook notation may be assigned to a company to indicate the likely direction the rating may move in the medium-term. This medium-term time horizon generally does not exceed two or three years. The following notations may be assigned: positive, negative, stable or developing. A “developing” outlook indicates that the rating may be raised or lowered.

Obtaining a credit rating can be a costly and lengthy process for a company. Furthermore, the rating is assigned based on publicly available information on the company, information supplied by third parties and information provided by the company itself. Such information includes financial statements, cash flow projections, business information, transaction agreements, and other applicable data. The evaluation also looks at specific industry factors and the vulnerability of the business to political, economic or regulatory changes.

The credit rating is made based on the assumption that the underlying information supplied to the credit rating agency is accurate and complete. However, the credit rating agency is not obligated to perform its own investigative due diligence.

Ratings are reviewed on at least an annual basis. Companies that are undergoing material changes, such as acquisitions, dispositions or major changes in capital structure, should promptly inform the credit rating agency of such developments. In the event that a company’s creditworthiness appears to be diminishing, a company may be placed on a watch list. A comprehensive analysis will be undertaken to determine whether a ratings downgrade should be issued. The agency will notify the company of the change in rating before publishing it.