Credit ratings provide retail and institutional investors with information that determines whether issuers of bonds, debt instruments, and fixed-income securities will meet their obligations. Credit rating agencies (CRAs) use letter grades to assign analyses and independent assessments of companies and countries that issue debt securities.
- Credit rating agencies give investors information about bond and debt instrument issuers.
- Agencies provide information about countries’ sovereign debt.
- The global credit rating industry is highly concentrated, with three leading agencies: Moody’s, Standard & Poor’s, and Fitch.
What Are Credit Ratings?
Countries are issued sovereign credit ratings. This rating analyzes the general creditworthiness of a country or foreign government. Sovereign credit ratings measure the overall economic conditions of a country, including the volume of foreign, public, and private investment, capital market transparency, and foreign currency reserves.
Ratings also assess conditions such as overall political stability and the level of economic stability a country will maintain during a political transition. Institutional investors rely on sovereign ratings to qualify and quantify the general investment atmosphere of a particular country.
Credit, debt, or bond ratings are issued to individual companies and specific classes of individual securities, such as preferred stock, corporate bonds, and various government bonds. Ratings can be assigned separately to both short-term and long-term obligations. Three agencies, Moody’s, Standard & Poor’s, and Fitch, control nearly the entire credit rating market.
Fitch operates in New York and London, basing ratings on company debt and its sensitivity to changes like interest rates. Countries request Fitch and other agencies to evaluate their financial situation and political and economic climates. John Knowles Fitch founded the Fitch Publishing Company in 1913 to provide financial statistics for the investment industry via “The Fitch Stock and Bond Manual” and “The Fitch Bond Book.”
In 1924, Fitch introduced the AAA through D rating system that has become the basis for ratings throughout the industry. Investment grade ratings from Fitch range from AAA to BBB. These letter grades indicate the potential for default on debt. Non-investment grade ratings range from BB to D, the latter meaning the debtor has defaulted.
In August 2023, Fitch Ratings downgraded the long-term ratings of the United States to “AA+” from “AAA” based on the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to “AA” and “AAA” peers over the last two decades with repeated debt limit standoffs and untimely resolutions.
Moody’s Investors Service
Moody’s assigns countries and company debt letter grades differently from Fitch. Investment grade debt goes from Aaa, the highest, to Baa3, where the debtor can repay short-term debt. Below investment grade is speculative-grade debt, which is often referred to as high-yield or junk. These grades range from Ba1 to C, with the likelihood of repayment dropping as the letter grade goes down.
John Moody and Company first published “Moody’s Manual” in 1900 with basic statistics and general information about stocks and bonds of various industries. From 1903 until the stock market crash in 1907, “Moody’s Manual” was a national publication. In 1909, Moody began publishing “Moody’s Analyses of Railroad Investments,” which added analytical information about the value of securities. Expanding this idea led to the 1914 creation of Moody’s Investors Service to provide ratings for nearly all government bond markets. In the 1970s and late ’80s, Moody’s began rating commercial paper and bank deposits, becoming the full-scale rating agency it is today.
Standard & Poor’s
“S&P has 10 letter-based ratings where “AA’ to ‘CCC’ may be modified with plus or minus symbols. Anything rated AAA to BBB- is considered investment grade, or the ability to repay debt. Debt rated BB+ to D is considered speculative, with an uncertain future. The lower the rating, the more potential it has to default, with a D rating as the worst.
Henry Varnum Poor first published the “History of Railroads and Canals in the United States” in 1860, the forerunner of securities analysis and reporting that would be developed over the next century. Standard Statistics was formed in 1906, which published corporate bonds, sovereign debt, and municipal bond ratings. Standard Statistics merged with Poor’s Publishing in 1941 to form Standard and Poor’s Corporation, which was acquired by The McGraw-Hill Companies in 1966.
Use of Ratings and NRSROs
By 1970, credit rating agencies recognized that objective credit ratings significantly helped issuers. Ratings facilitated access to capital by increasing a securities issuer’s value in the marketplace and decreasing the costs of obtaining capital. Expansion and complexity in the capital markets, coupled with an increasing demand for statistical and analytical services, led to the industry-wide decision to charge issuers of securities fees for rating services.
In 1975, financial institutions such as commercial banks and securities broker-dealers sought to soften the capital and liquidity requirements passed down by the Securities and Exchange Commission (SEC). As a result, nationally recognized statistical ratings organizations (NRSROs) were created. Financial institutions could satisfy their capital requirements by investing in securities that received favorable ratings from one or more NRSROs.
The increased demand for rating services by investors and securities issuers, combined with increased regulatory oversight, has led to growth and expansion in the credit ratings industry.
Are Credit Rating Agencies Regulated?
The Credit Rating Agency Reform Act of 2006 allowed the SEC to regulate the internal processes, record-keeping, and business practices of CRAs in the U.S. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, commonly referred to as Dodd-Frank, further grew the regulatory powers of the SEC, including the requirement of a disclosure of credit rating methodologies.The European Union (EU) has never produced legislation or created a singular agency responsible for CRAs. Several EU directives, such as the Capital Requirements Directive of 2006, affect rating agencies, business practices, and their disclosure requirements. Most directives and regulations are the responsibility of the European Securities and Markets Authority.
Can Credit Ratings Affect a Country’s Economic Stability?
Credit rating agencies came under scrutiny and regulatory pressure following the financial crisis and the Great Recession of 2007 to 2009. It was argued that CRAs provided inaccurate positive ratings, leading to bad investments, and the agencies gave mortgage-backed securities (MBSs) AAA ratings. The agencies were accused of trying to raise profits and their market share in exchange for these inaccurate ratings. This helped lead to the subprime mortgage market collapse that led to the financial crisis.
Why Are There Only Three Leading Credit Rating Agencies?
Some have argued that regulators have helped to prop up an oligopoly in the credit rating industry with rules that act as barriers to entry for small- or mid-sized agencies.
The Bottom Line
Investors utilize information from a single agency or multiple rating agencies. Investors expect credit rating agencies to provide objective information based on sound analytical methods and accurate statistical measurements. Credit rating agencies should comply with reporting procedures developed by securities industry governing agencies.