Credit Quality

What Is Credit Quality?

Credit quality is a measurement of an individual's or company's creditworthiness, or the ability to repay its debt. Credit quality is an indicator of credit risk. Credit quality is also one of the principal criteria used for judging the investment quality of a bond or a bond mutual fund.

The credit quality of a company that issues bonds is assessed through bond ratings. The credit quality of other firms (including insurance firms) and of securities is assessed through credit ratings. Credit ratings assess the riskiness of these firms. For individuals, a FICO score is the most common measure of an individual's credit quality.

Understanding Credit Quality

A FICO score is the most common measure of an individual's credit quality. A FICO score is a type of credit score that was created by FICO (formerly the Fair Isaac Corporation), a major analytics software company that provides products and services to both businesses and consumers.

Lenders may use an individual's FICO score (along with other details on an individual's credit reports) as a way of assessing their credit risk and, ultimately, making a decision about whether or not to extend credit to them. The score is a mathematical summary of the information on a person's credit report, and the score assigned to an individual can range from 300 to 850. In general, the higher a person's FICO score, the more creditworthy that person is considered to and the more likely they are to be lent money or issued credit. In addition, having a high FICO score tends to help borrowers get the best interest rate. In general, scores above 650 indicate a very good credit history; the best interest rates tend to go to borrowers with FICO scores above 740.

A bond rating is a measure of the credit quality of a bond issuer. A bond rating can be assigned to an individual bond issuer or to a portfolio of bonds. Bond ratings are determined by private independent bond rating agencies, such as Standard & Poor's, Moody's, and Fitch, among others. Each rating agency has its own designations. Most designations range from high (or AAA to AA), medium (or A to BBB), and low (or BB, B, CCC, CC to C).

In the credit market, high credit ratings are also referred to as investment-grade ratings. Investment-grade bonds typically have ratings of AAA, AA, A, or BBB. Non-investment-grade bonds, also referred to as high-yield or junk bonds, have lower credit quality and, therefore, usually present a higher risk to investors. Non-investment-grade bonds typically have ratings of BB, B, CCC, CC, and C. These ratings indicate that there's a good chance that the bond issuer will renege on its obligations, or default. In fact, D, the lowest grade, is reserved for bonds that are already in default.

While investment-grade bonds often have lower yields, non-investment grade bonds typically offer investors higher yields (in order to offset the greater risk). Investors interested in the safety of their bond investments should stick to investment-grade bonds with ratings of AAA, AA, A, or BBB. For example, an investor that holds a bond that is rated AAA has a higher likelihood of collecting all their coupons and principal.

For investors who are willing to accept a higher level of risk, they may consider lower credit-quality bonds with higher yields. For bonds rated BB, B, CCC, CC, and C, there's a good chance that the bond issuer will renege on its obligations, or default. A rating of D is the lowest possible bond rating, and it is reserved for bonds that are already in default.

Credit rating agencies–such as Moody's and Standard & Poor's–also issue credit quality ratings for all types of firms in the credit market. Corporate credit ratings are based on a firm's financial statements, including the specific company’s capital structure, credit payment history, revenue, and earnings. Corporate credit ratings are meant to help assess the firm's ability to pay its debts. When credit rating companies assign a letter grade to a company's debt, AAA typically indicates the highest credit quality and D indicates the lowest.