Have you ever seen a bank, insurance company, finance company or financial institution advertising their credit rating? Given the huge amount of information and all the different types of ratings, it's hardly surprising many people are confused about what they actually mean. With the recent failure of several finance companies it's important to get an understanding of how ratings work.
Simply put, a credit rating is an objective, independent assessment of an institution's ability to meet its financial commitments. Effectively it tells you how financially secure the respective company is and therefore the likelihood of you getting your money back when you invest it. It helps you determine what the level of risk of the investment is and if the investment rate being paid is worth the level of risk.
For example lets assume you are comparing whether to invest into New Zealand Government Bonds (which have the highest possible credit rating of AAA from Standard & Poor's) at 7.5% p.a. before tax (effectively this is the risk free rate) and a company like South Canterbury Finance which is rated BBB- and is offering say 9% p.a. before tax. By having the credit rating, the investor is able to assess whether the extra 1.5% South Canterbury is providing (over the risk free rate), is sufficient return for the extra risk, because BBB- is a lower rating than AAA. The best way to quantify the level of risk is to look at what the credit rating means in terms of the probability of default, i.e. the risk that the company will be unable to pay interest and/or principal.
The most respected ratings tend to be provided by the 'big three' international, mainstream rating agencies (S&P, Moodys and Fitch) because they have well developed processes, long track records and deep sets of default data. Not all non bank finance companies in New Zealand currently have a rating, however it is likely that this will change in the future.
I would be interested to hear anyone's views.