Rating: Definition in Finance, How It Works, Types, Agencies

What Is a Rating?

A rating is an assessment tool assigned by an analyst or rating agency to a stock or bond. The rating assigned indicates the stock or bond's level of investment opportunity. The three major rating agencies are Standard & Poor's, Moody's Investors Service, and Fitch Ratings. 

How a Rating Works

Analysts who work on both the buy-side and sell-side of the industry research stocks and write opinions on those stocks, which will often include a rating such as "buy", "hold " or "sell". Meanwhile, bonds are rated by the three major bond rating agencies. 

Types of Ratings

Analyst Ratings

Analysts on the buy-side will write opinions for their teams for the purposes of informing portfolio management decisions. Analysts on the sell-side will write opinions to educate others on their research and in an attempt to sell particular stocks on behalf of clients. For a stock, an analyst may assign a "buy", "hold " or "sell" rating and an explanation of why they recommend this action for the stock. 

When it comes to major Wall Street banks and institutions, they all use different terminology and classifications. Morgan Stanley, for example, uses the terms "overweight", "equal-weight", and "underweight". The timeline for its ratings is 12 to 18 months. Credit Suisse uses the terms "outperform," "neutral", and "underperform", which is based on a 12-month time period. All of these terms are variations of the "buy", "hold", and "sell" ratings.

Rating Agency Ratings 

For a bond, a rating agency will assess the bond's relative safety based upon the issuing entity's fundamental financial picture, which scrutinizes the issuer's ability to repay the principal and make interest payments.

The ratings for Moody's and S&P from highest to lowest in the investment grade category are Aaa/AAA, Aa1/AA+, Aa2/AA, Aa3/AA-, A1/A+, A2/A, A3/A-, Baa1/BBB+, Baa2/BBB and Baa3/BBB-.

Standard & Poor's is the provider of the S&P 500 Index, as well as a leading data source and index provider of independent credit ratings. S&P 500 Index is a widely utilized gauge for determining the overall condition of the U.S. stock market.

Moody's is a provider of international financial research on government and commercial issued bonds. Moody's utilizes a rating system to judge a borrower's creditworthiness. This rating scale goes starts at Aaa (being of the highest quality) and goes to C (being of the lowest quality).

Fitch Ratings is also a credit rating agency that is international. This agency bases its ratings on factors such as how sensitive a company is to internal changes and the kind of debt the company holds. Fitch is used by investors as a guide to what investments will not default and will, in turn, lead to a solid return.

The ratings assigned by the various rating agencies are based primarily upon the insurer's or issuer's creditworthiness. This rating can, therefore, be interpreted as a direct measure of the probability of default. However, credit stability and priority of payment are also factored into the rating.