What Are Credit Ratings?

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Written By SmarterrMoney.org

The latest in personal finance to help you make smarter money choices. 

A credit rating measures an entity’s likelihood to repay money that it has borrowed. 

Why Do Municipal Credit Ratings Matter?

When investors purchase bonds from municipalities, they risk that the issuer (the municipality) will become unable to repay the bond plus interest.

Credit rating agencies measure a bond issuer’s economic base, historical fiscal results, and their ability to plan and budget to estimate this risk. They produce a credit rating investors can use to decide if a bond is worth the risk.

There are four rating agencies in the US: S&P Global Ratings (S&P), Moody’s, Fitch Group, and Kroll Bond Rating Agency. Each evaluates a different mix of factors to produce an issuer’s credit rating as a letter grade. 

Their ratings tend to be close but can differ slightly depending on what each particular agency looks at.

That said, not all bonds get rated by all agencies. Many only get two or three ratings.

Imagine a municipality that governs an area with a rapidly growing economy, a large population of high earners, and a significant, diverse tax base. These all indicate a high likelihood of paying back a general obligation bond, so they would likely get a high credit rating.

What’s important here?

The higher a municipality’s credit rating, the lower the yield has to be set on a bond to attract investors. Since the bond is seen as less risky, investors tend to be satisfied with a lower yield than if the bond was issued by a municipality with a lower rating. 

A sufficiently high grade can earn the issuer the “investment-grade security” title to show investors the relatively low risk of investing in that bond. This can help an issuer in selling bonds affordably.

Some municipalities may choose to avoid getting a rating, but this generally looks bad to investors. It tells them the issuer is worried about getting a low rating, which implies weak creditworthiness.

It’s worth noting that agencies judge a bond issuer’s economic base differently for general obligation issuances and revenue obligation issuances. This is because the former can be repaid with any revenues the issuer earns, such as taxes and fees, whereas the latter must use project revenues attributable to the bond to repay.

These agencies typically look at the following for GO issuances:

  • Economic diversity in the tax base 
  • Growth in employment opportunities
  • Economic base trends in population
  • Employment and personal income

As for revenue obligation issuances, they review:

  • Need of the project in the area
  • Management of the project
  • Any competing project within the area
  • Bond indenture feature (such as if there’s a debt service reserve fund)
  • Rate setting ability (such as the ability to increase tolls with little loss of road usage)