Bond rating agencies are companies that assess the creditworthiness of both debt securities and their issuers. These agencies publish the ratings used by investment professionals to determine the likelihood that the debt will be repaid.
Key Takeaways
- Bond rating agencies are companies that assess the creditworthiness of both debt securities and their issuers.
- The three primary bond rating agencies used in the U.S. are Standard & Poor's Global Ratings, Moody's, and Fitch Ratings.
- The bond rating agencies provide useful information to the markets and help investors save on research costs.
- Rating agencies are regulated by the SEC in addition to various reform acts such as CRARA and Dodd-Frank.
- Bond rating agencies were heavily criticized early in the 21st century for assigning flawed ratings, particularly for mortgage-backed securities.
Understanding Bond Rating Agencies
The three primary bond rating agencies in the U.S. are Global Ratings, Moody's, and Fitch Ratings. Each uses a unique letter-based rating system to quickly convey to investors whether a bond carries a low or high default risk and whether the issuer is financially stable.
Standard & Poor's highest rating is AAA, and a bond is no longer considered investment grade if it falls to BB+ status. The lowest rating, D, indicates that the bond is in default. That means the issuer is delinquent in making interest payments and principal repayments to its bondholders.
In general, Moody's assigns bond credit ratings of Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C. Standard & Poor's and Fitch assign bond credit ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, and D, with the latter denoting a bond issuer in default.
The agencies rate bonds at the time they are issued. They periodically reevaluate bonds and their issuers to see if they should change the ratings. Bond ratings are important because they affect the interest rates that companies and government agencies pay on their issued bonds.
The top three bond rating agencies are private firms that rate corporate and municipal bonds based on the associated degree of risk. They sell the ratings for publication in the financial press and daily newspapers. Other bond rating agencies in the United States include Kroll Bond Rating Agency (KBRA), , and Egan-Jones Ratings (EJR) Company.
Bond Rating Agency Methodologies
To give credit ratings to organizations like governments, businesses, and financial instruments, rating agencies utilize a variety of approaches. The approaches and methodologies may include but are not limited to:
- Financial Indicators: Rating agencies examine financial variables to determine the creditworthiness of a company. Financial statements, cash flow analysis, debt ratios, profitability measurements, and liquidity measures are a few examples of these indicators.
- Industry Analysis: When rating a company, rating agencies take into account the risks and characteristics of the industry in which it works. They assess the market circ*mstances, competitive factors, regulatory environment, industry dynamics, and possible dangers that are exclusive to that sector.
- Macroeconomics: Rating agencies examine macroeconomic elements that may have an impact on an entity's creditworthiness. GDP expansion, inflation, interest rates, currency rates, and political stability are a few examples of these variables.
In addition to the methodologies above, rating agencies may apply variations across each rating agency. For example, various credit ratings for the same company may vary across rating agencies due to the varying weights of these methodologies.
In addition, rating agencies may have a variety of specialties and areas of interest. Some agencies may have areas of expertise in particular industries or classes of financial instruments, which can cause differences in the breadth of industry research and the comprehension of risks unique to each sector.
Rating Agency Regulatory Framework
Rating agencies are subject to different regulatory frameworks. At the top, the Securities and Exchange Commission (SEC) is the principal regulatory body in charge of regulating rating agencies in the United States. The SEC has the authority to register, regulate, and oversee nationally recognized statistical rating organizations (NRSROs) which are the rating agencies recognized by the SEC as credible and influential in the U.S. market.
The U.S. Congress approved the Credit Rating Agency Reform Act (CRARA) in 2006 in reaction to the financial crisis of 2008.
The SEC has established a code of conduct that NRSROs must follow. The code of conduct places a strong emphasis on the necessity for independence, avoiding conflicts of interest, and giving ratings that are fair and truthful. Additionally, it requires that techniques, rating results, and any conflicts of interest be disclosed.
Last, in addition to local laws, there may be international regulatory frameworks that apply to rating agencies. For instance, the International Organization of Securities Commissions (IOSCO) has produced a Code of Conduct Fundamentals for Credit Rating Agencies that outlines international standards and principles for the operations of rating agencies.
Last updated in 2021, a study by the Federal Reserve found that a data set of 2,000 credit ratings strongly indicated there was no influence by the rating agency's conflict of interest.
Benefits of Bond Rating Agencies
Although bond rating agencies were heavily criticized early in the 21st century, they continue to perform valuable functions for investors. A variety of exchange-traded funds (ETFs) depend on bond ratings for their purchases. For example, an investment-grade bond ETF will buy or sell bonds depending on the ratings that they receive from the bond rating agencies. In this way, the agencies act similarly to fund managers charged with investing in securities of sufficient quality.
The bond rating agencies provide useful information to the markets; however, they are not responsible for the often irrational ways that investors and funds respond to that information. Even managed mutual funds frequently have rules that require them to sell bonds that fall below a specific credit rating. A rating downgrade can cause a downward spiral of forced selling, creating bargains for investors in fallen angel bonds.
Criticism of Bond Rating Agencies
Since the 2008 credit crisis, rating agencies have been criticized for not identifying all of the risks that could impact a security's creditworthiness. In particular, they were blamed for giving high credit ratings to mortgage-backed securities (MBS) that turned out to be high-risk investments.
Investors continue to be concerned about possible conflicts of interest. Bond issuers pay the agencies for the service of providing ratings, and no one wants to pay for a low rating. Because of these and other shortcomings, ratings should not be the only factor investors rely on when assessing the risk of a particular bond investment.
On the other hand, bond rating agencies have also been criticized for causing financial losses by making dubious rating downgrades. Most famously, S&P downgraded the U.S. federal government's credit rating from AAA to AA+ during the 2011 debt ceiling crisis.
In August, 2023, Fitch downgraded the U.S. government's rating from AAA to AA+ due to "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' rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions."
In December of 2023, Moody's also lowered its outlook on the U.S. credit rating to "negative" from "stable," citing looming fiscal deficits and rising debt service.
In point of fact, the Federal Reserve can always print more money to pay interest. Furthermore, the U.S. government showed no signs of defaulting during the following decade. Nonetheless, stock prices experienced a significant correction in 2011. Some innocent companies ended up paying higher interest on their debts; however, the market showed its lack of confidence in S&P's downgrade by sending U.S. Treasury bond prices higher.
The relatively discrete way in which the agencies rate bonds also generally makes market volatility unnecessarily high. The most extreme case occurs when the agencies downgrade a nation's debt from investment grade to junk status. A more continuous system would give markets more time to adjust.
How Do Rating Agencies Assign Credit Ratings?
Rating agencies assign credit ratings based on their methodologies, which consider factors like financial indicators, industry analysis, and macroeconomic conditions. They analyze an entity's financial health, industry risks, and broader economic factors to determine the likelihood of default or creditworthiness. The ratings typically range from AAA (highest) to D (default).
How Transparent Are Rating Agencies in Their Methodologies?
Rating agencies vary in their transparency regarding methodologies. While they disclose some aspects of their processes, they may not provide full details due to proprietary concerns. Some agencies offer more transparency by providing information about their methodologies, assumptions, and rating rationales, while others may provide relatively less information, which can impact understanding and scrutiny.
How Do Rating Agencies Impact Investments and Borrowing Costs?
Credit ratings play a significant role in investment decisions and borrowing costs. Highly-rated entities benefit from lower borrowing costs as investors perceive them as less risky. A downgrade or upgrade in a credit rating can impact an entity's ability to access capital markets and affect the pricing of bonds, loans, and other financial instruments.
How Do Rating Agencies Assess Non-Financial Sectors, Such as Governments?
Rating agencies assess non-financial sectors, including governments, by analyzing factors specific to those sectors. For governments, they consider fiscal discipline, economic growth prospects, debt levels, political stability, and institutional strength. Be mindful that each rating agency has its own methodology and criteria to evaluate the creditworthiness of governments and other non-financial sectors.
The Bottom Line
Rating agencies in the United States, regulated by the Securities and Exchange Commission (SEC), assess the creditworthiness of entities and assign credit ratings. They consider financial indicators, industry analysis, and macroeconomic factors in their methodologies. The major rating agencies in the U.S. include Standard & Poor's (S&P), Moody's, and Fitch Ratings. While they follow similar principles, there are differences in their methodologies, rating scales, and expertise.
