Public Finance Division
The Credit Rating Process
What is a Credit Rating?
A credit rating is an independent assessment of the creditworthiness of a bond (note or any security of indebtedness) by a credit rating agency. It measures the probability of the timely repayment of principal and interest of a bond. Generally, a higher credit rating would lead to a more favorable effect on the marketability of a bond. The credit rating symbols (long-term) are generally assigned with "triple A" as the highest and "triple B" (or Baa) as the lowest in investment grade (See below for definition of rating grades). Anything below triple B is commonly known as a "junk bond."
Rating Definitions - Investment Grades
- AAA (Aaa)
- Bonds rated AAA have the highest ratings assigned by rating agencies. They carry the smallest degree of investment risk. Issuer's capacity to pay interest and principal is extremely strong.
- AA (Aa)
- Bonds rated AA are judged to be of high quality by all standards. They differ from the highest rated (AAA) bonds only in a small degree. Issuer's capacity to pay interest and principal is very strong.
- A
- Bonds rated A have strong capacity to pay interest and repay principal although they are somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than bonds in higher rated categories.
- BBB (Baa)
- Bonds rated (BBB) are considered medium grade obligations. They are neither highly protected nor poorly secured. Interest payments and principal security appear adequate for the present but certain protective elements may be lacking or unreliable over any length of time. These bonds lack outstanding important characteristics and have speculative characteristics as well.
- + / - / 1, 2, 3
- Relative standing within a rating category
Who are the credit rating agencies?
Currently, the following rating agencies rate California's general obligation bonds, notes, lease-purchase revenue bonds and commercial papers:
How are bonds rated?
The rating process begins with an application to the rating agencies by the issuer or its agent either via a telephone call or in writing. The State of California has engaged Standard & Poor's, Moody's and Fitch in rating all its debt instruments for decades. (See History of California General Obligation Bond Credit Rating)
The rating request is usually done several weeks before the issuance of the bonds to allow time for the rating agencies to perform their review and analysis. Generally, the following documentations are provided to the rating agencies as soon as possible:
- the preliminary official statement;
- latest audited and unaudited financial statements;
- the latest budget information, including economic assumptions and trends;
- capital outlay plans;
- the bond counsel opinion addressing the authority and tax-exempt status of the bond issuance;
- all legal documents relating to the security for the bonds; and
- any other documents that may pertain to the bond issuance as requested by the rating agencies.
Following this, a meeting is set up at the rating agency's or issuer's office to present the creditworthiness. The credit analyst prepares a municipal credit report which discusses key analytical factors. The credit analyst presents credit for "sign-off" with the senior analyst and makes a recommendation for rating. The credit analyst makes a presentation before a rating committee comprised of senior analysts. Finally, the rating is released to the issuer, then to a wire service, followed by a publication of full credit report.
What are the elements involved in determining a credit rating?
- Economic Factors
- Evaluation of historical and current economic factors
- Economic diversity
- Response to business cycles
- Economic restructuring
- Assessing the quality of life in the given area
- Debt/Issue Structure
- Economic feasibility and need for project
- Length of bond's maturity, short-term debt financing
- Pledged security and other bondholder protections
- Futuristic outlook: capital improvement plan
- Financial Factors
- Sufficient resources accumulated to meet unforeseen contingencies and liquidity requirements
- On-going operations are financed with recurring revenues
- Prudent investing of cash balances
- Ability to meet expenditures within economic base
- Management/Structural Factors
- Organization of government and management
- Taxes and tax limits
- Clear delineation of financial and budgetary responsibilities
- Expanded Analytical Topics
- Investment Policies and Practices
- Portfolio composition-credit risk, diversification, and market risk
- Leverage-increase of assets to enhance yield
- Liquidity Management-portfolio maturity profile that matches cash flow
- Infrastructure needs
- Willingness to Pay
- Effective and timely budget response
- Willingness to bring budget into balance and still pay debt
- Willingness to make payment
- Continuing Disclosure