Credit ratings are generally split into two groups, investment grade and speculative. On the top there, you can see investment grade, which runs from the safest, AAA, down to BBB minus. Now, these are seen as very safe. If you lend to companies with these ratings, you're probably going to get your principal and you're probably going to get your interest and it's all going to be on time. We could quantify that by taking a look at the diagram. You can see the investment grade, which is on the left hand side of the diagram, has very, very low default rates over a five year cumulative period. And what that means, if we Zoom in on a BBB, is that a company that is rated BBB, you're only gonna have a 2% chance of being paid late, or not getting your principal back. Now, if we compare that to companies which are on the lower part of that diagram, these are called speculative, or non-investment grade companies. These indicate quite a high level of risk, and you can see that the risk is actually going up exponentially. If we were to Zoom in on a double B, there's an 8% chance that something is going to go wrong with the lending, and this ramps up to quite a large 46, or 47% when you get to a lowest C rating. And what that means is that if you were to lend to a company like this over a five-year period, there's just under half chance, so 47% chance, that something is gonna go wrong. So, how do we come up with these credit ratings? First of all, we assess business risk. And this has a lot of factors to consider. If we just zoom in on one of them, country risk, the company might be operating in a country with a reasonably high chance of political unrest. This would then create uncertainty around cash flows, and the ability of the company to repay its debt. Another category of analysis would be financial risk. And this would involve a lot of number crunching on the accounts to find out whether the cash flows are sufficient to repay the debt. But it could also contain some qualitative stuff like the country again. If policies around governance in that country are particularly weak, again, it may cast some doubt on the company's ability to repay, or the trustworthiness of the accounts that we're analysing. Suitability of the capital structure and liquidity, so both the business risk and the financial risk, are then combined to generate an issuer rating, and this represents the overall credit rating for the company. The issuer rating, the umbrella rating as it's called on the diagram, would normally be the highest rating to any debt issued by the company. Individual debt issues could then be rated individually. They'd be rated separately and they'd often be notched down, downgraded, from the issuer rating depending on seniority. In other words, if a company has a rating of BBB+, so pretty good, that would be the issuer rating. The most senior ranking debt would probably have the same rating, so BBB+. The lower ranking debt might have BBB+, or below, depending on the overall leverage of the issuer, priority claims and the likelihood of repayment.
