As the number and complexity of financial instruments in the global financial markets have increased in recent decades, credit ratings have assumed an increasing importance to provide informational support to individual and institutional investors, in the opportunity of their better informed investment decision making. Rating agencies are often considered the guardians of the capital market, due to the impact of their opinions on the structuring and pricing of financial products. The product of a credit rating agency seems simple enough. It is a letter “grade” that indicates the probability of default of a debt instrument. The ratings reflect both the probability of default and any financial loss suffered in the event of default. An event of default is generally defined as the failure to pay interest or principal on a debt obligation at maturity.

In other words, a credit rating is an opinion about the overall creditworthiness of an issuer or one of the specific issues made by the issuer. The rating is based on any risk factors that the rating agency believes are relevant to the likelihood that the issuer will honor the terms of a financial contract. Because ratings are evaluated in terms of default risk, the historical frequency of defaults is expected to be higher for lower-rated securities. One of the main consequences of a higher rating is its potential impact on investors’ perception of risk. In this sense, given that lower ratings correspond to higher default rates, investors demand higher returns for lower-rated bonds to compensate for the higher risk. This required rate is typically quoted as an additional return, or “spread”, on bonds. A rating is given based on an assessment of the risks faced by the issuer at any given time. Issuers that change their ability to honor financial commitments may have their rating changed. It is common for rating agencies to recognize the possibility that future performance may deviate from initial expectations. Rating outlooks address this issue by focusing on scenarios that could result in a rating change.