Credit Scores And Credit Ratings

Credit scoring is used for small businesses and individuals. A higher credit score indicates better credit quality. FICO is a well known example of a credit scoring model used in the United States.

FICO scores are higher for those with (a) longer credit histories (age of oldest account), (b) absence of delinquencies, (c) lower utilization (outstanding balance divided by available credit line), (d) fewer credit inquires, and (e) a wider variety of types of credit used.

Credit ratings are issued for corporate debt, asset backed securities, and government and quasi government debt. Similar to credit scores, credit ratings are ordinal ratings (higher = better). Three major global credit rating agencies are Moody’s Investor Service, Standard & Poor’s, and Fitch Ratings.

The issuer rating for a company is typically for its senior unsecured debt. Ratings on other classes of debt by the same issuer may be notched. Notching is the practice of lowering the rating by one or more levels for more subordinate debt of the issuer.

Notching accounts for LGD differences between different classes of debt by the same issuer (higher LGD for issues with lower seniority).

In addition to a letter grade, rating agencies provide an outlook (positive, negative, or stable). Higher rated bonds trade at lower spreads relative to their benchmark rates.

Bond portfolio managers often want to evaluate the performance of a bond in the event of credit migration (i.e., change in rating). A change in a credit rating generally reflects a change in the bond’s credit risk. The change in the price of the bond depends on the modified duration of the bond and the change in spread resulting from the change in credit risk as reflected by the credit migration.