Credit quality is the ability of a debt issuer to meet its future payment commitments, both on time and in form.
Credit quality therefore assesses the probability of default of a certain specific financial obligation by the debt issuer. On the one hand, a good credit quality indicates that the financial obligation in question has little risk of default. And, on the other hand, a very poor credit quality means that the probabilities that the issuing entity will be able to pay its debt in accordance with the agreed conditions are quite low.
Credit quality rating
If we look at the strict concept of credit quality, the truth is that we cannot speak of "types" or "varieties" of credit quality since it is good or bad, better or worse.
However, we can establish an order of priority for the debt issued by the issuing bodies. Associating, in this way, the concept of credit quality to the level of default risk in the event of liquidation.
Depending on the issuer of the debt we can distinguish:
- Public debt (sovereign): Generally, this type of financial assets have the best credit quality in the market since, in normal scenarios, States have a greater capacity to meet their payment commitments compared to private entities. Treasury bills, State bonds and State obligations are examples of financial products of Public Debt. However, it should be noted that this is not always the case.
- Interbank debt : Financial entities continually lend each other money with a very short-term time horizon and high liquidity. Therefore, they also tend to have good credit quality. The typical product that we would find in this category is bank deposits.
- Corporate debt : This is the debt assumed by any person, physical or legal, that is not a Public Administration. It usually has a lower credit quality. Within corporate debt we can distinguish:
- Senior secured debt
- Senior debt
- Subordinated debt
- Hybrid debt
- Stocks : In this case, we would not be speaking properly of debt, but of investment in capital.
Main functions of credit quality
Among the main functions of credit quality are:
- Facilitate, from the investor’s point of view, the perception of the degree of solvency of a certain issuer.
- Report, from the regulatory point of view, on the level of risk assumed by the issuing entities to the competent supervisory bodies.
- Guide, from the market point of view, the different economic agents that intervene in the market (Collective Investment Institutions, SICAV, etc.) on the credit capacity of the different issuers with a view to their investment decisions.
How is credit quality measured?
The process of evaluating the credit quality of a given issuer is commonly known as Credit Rating – Rating. Said rating reflects the reasoned opinion on the issuer’s credit quality by a series of organizations specialized in financial services, the rating agencies.
The usual process by which agencies give their opinion on credit quality begins with gathering a large amount of information about the issuer. On the one hand, purely economic-financial information is analyzed (balance sheets, profit and loss accounts, payment history, etc.) and, on the other, market information (price history, situation of the sector in which it operates, etc.).
This information is usually complemented by conducting interviews and meetings with the management staff of the issuing entity. Once all the data has been collected and interpreted, the analysts issue a specific rating in the form of an alphanumeric code which meets different criteria depending on the rating agency in question. In other words, there is no standard credit rating code that is shared by each and every one of the agencies, but rather each one uses its own nomenclature.