What Is Credit Quality?
Credit quality is a measure of the financial solvency of an individual or an entity such as a company or a government. Specifically, it is an evaluation of the ability of that person or entity to repaytheir debts.
A principal criterion for judging the investment quality of a bond or a bond mutual fund is the credit quality of the company or government issuing the bond or bonds.
Key Takeaways
- Credit quality is routinely measured when an individual or an entity like a company seeks to borrow money.
- It is an independent judgment of the financial solvency of the person or entity.
- The credit quality of individuals is usually summed up by a credit score.
- The credit quality of companies, governments, and other entities is expressed in terms of a credit rating.
- Possessing good credit quality generally means paying less to borrow money, whether it's a consumer buying a car or a government issuing a bond.
Credit Quality and Individuals
The creditworthiness of an individual is determined most commonly through the person's credit score.
The creditworthiness of American consumers is most often determined by a FICO score. This is a credit score compiled using a methodology developed by the Fair Isaac Corporation (FICO) and based on factors including the individual's current amount of debt, number of active credit lines, and length of credit history.
The facts that are fed into individual FICO scores are compiled and tracked by several credit reporting agencies including Equifax, TransUnion, and Experian.
FICO is the oldest and most widely used credit score, but it has newer competitors such as VantageScore.
Lenders use credit scores, along with other details in individualcredit reports, as a way of assessing applicant credit risks and, ultimately, making a decision about whether or not to extend credit. Credit scores also are checked by insurance companies, employers, landlords, and others as a means of determining a person's credit quality.
The Math of Credit Scoring
In essence, a credit score is a mathematical summary of the information in a person'scredit reports, ranked on a scale ranging from 300 to 850.
Credit scoring formulas assign weights to various aspects of a person's credit history. FICO scores give the highest weight to payment history (whether the person has consistently paid their credit bills on time), which accounts for 35% of their score. Amounts owed, including their credit utilization ratio) counts for 30%. Length of credit history (older accounts are better) counts for 15%. New accounts (too many of them is a negative) and credit mix (having a variety of credit types, such as a credit card and a mortgage, is a plus) count for 10% each.
The higher a person's credit score, the more creditworthy that person is considered to be. Having a high credit score also helps borrowers get more favorable interest rates. Scores above 670 are generally considered good or better.
An individual may have multiple credit scores from any or all of the credit rating agencies. In addition, there are slightly different scoring models for use by mortgage companies, auto lenders, and credit card issuers.
An individual's various credit scores should be close if not identical. An extreme difference may indicate an error in one of the reports.
Credit Quality and Companies or Other Bond Issuers
Credit ratings are to corporations and other bond issuers what credit scores are to individuals, a form of shorthand for describing their credit quality. A credit rating can be assigned to an entire company or to a particular issue of its bonds.
Also referred to as bond ratings, credit ratings are assigned by independent bond rating agencies including Fitch Ratings, Moody's Investors Service, and . Another major company, AM Best, specializes in ratings of insurance companies.
Each rating agency has its own alphabetical designations, although they are relatively similar. Most range from high (AAA to AA), to medium (A to BBB), and low (BB, B, CCC, CC, C, and D).
Rating agencies are typically paid by the companies they rate.
In the credit markets, high credit ratings are also referred to as investment-grade ratings. Investment-grade bonds typically have ratings of AAA, AA, A, or BBB.
About Junk Bonds
Non-investment-grade bonds, also called high-yield or junk bonds, are judged to have lower credit quality and, therefore, present a higher risk to investors.
Non-investment-grade bonds typically have ratings of BB and lower. These ratings indicate that there's a greater chance that the bond issuer will default on its payment.
In fact, D, the lowest grade, is reserved for bonds that are already in default.
Non-investment-grade bonds typically offer higher rates of return to compensate for the greater potential risk.
There are bond mutual funds and ETFs that specialize in bonds of different grades.
How Companies Are Rated
Corporate credit ratings are based on a firm's financial statements, including its capital structure, credit payment history, revenue, and earnings. Corporate credit ratings are meant to help assess the firm's ability to pay its debts.
Credit rating agencies also assign ratings to insurance companies to indicate their financial strength and likely ability to pay future claims.
Governments and government agencies that issue debt are rated individually. As with any entity that borrows money, the credit rating reflects the government or agency's ability to repay its debts.
The credit rating agencies stress that their ratings are basically well-informed judgment calls. S&P Global, for example, refers to its ratings as "forward-looking opinions about the ability and willingness of debt issuers, like corporations or governments, to meet their financial obligations on time and in full" and as just "one of many inputs" for investors to consider.
How Can I Check My Credit Score?
It's quite easy to keep an eye on your credit score these days.
Many banks and credit card issuers display an account holder's score from one of the three major credit report companies on their websites. This is usually a selection under the "account services" section.
A number of personal finance websites give individuals access to free credit scores. These may be updated weekly or monthly, and a fee may be charged for more frequent updates.
Bear in mind that you can have multiple credit scores, so the one you obtain for free may not be identical to the one a particular lender is using.
How Can I Obtain My Credit Report?
By law, consumers are entitled to at least one free credit report a year from each of the three major credit bureaus, Equifax, Experian, and TransUnion. The official website for that purpose is AnnualCreditReport.com.
How Can I Check Credit Ratings for Bonds?
Credit ratings can be checked on the websites of the three big credit rating agencies: Fitch Ratings, Moody's Investors Service, and .
The Bottom Line
Credit scores and credit ratings are informed judgments of the credit quality of individuals and entities, respectively. Both are useful to lenders, investors, and others.
It's worth remembering that their number or letter grades are simply estimates and shouldn't be considered perfectly predictive.
