Before you decide whether to invest into a debt security from a company or foreign country, you must determine whether the prospective entity will be able to meet its obligations. A ratings company can help you do this. Providing independent, objective assessments of the credit worthiness of companies and countries, a credit ratings company helps investors decide how risky it is to invest money in a certain country and/or security.
Credit in the Investment World
As investment opportunities become more global and diverse, it is difficult to decide not only which companies, but also which countries, are good investment opportunities. There are advantages to investing in foreign markets, but the risks associated with sending money abroad are considerably higher than those associated with investing in your own domestic market. It is important to gain insight into different investment environments and to understand the risks and advantages these environments pose. Measuring the ability and willingness of an entity - which could be a person, corporation, security or country - to keep its financial commitments or its debt, credit ratings are essential tools for helping you make investment decisions.
Three top agencies deal in credit ratings: Moody's, Standard & Poor's (S&P's) and Fitch Ratings. Each of these agencies aims to provide a rating system to help investors determine the risk associated with investing in a specific company, investing instrument or market.
Ratings can be assigned to short-term and long-term debt obligations as well as securities, loans, preferred stock and insurance companies. Long-term credit ratings tend to be more indicative of a country's investment surroundings and/or a company's ability to honor its debt responsibilities.
For a government or company, it is sometimes easier to pay back local-currency obligations than to pay foreign-currency obligations. The ratings, therefore, assess an entity's ability to pay debts in both foreign and local currencies. A lack of foreign reserves, for example, may warrant a lower rating for those obligations a country made in foreign currency.
Ratings are not equal to or the same as buy, sell or hold recommendations. Ratings measure an entity's ability and willingness to repay debt.
The Ratings Are In
The ratings lie on a spectrum ranging between highest credit quality on one end and default or "junk" on the other. Long-term credit ratings are denoted with a letter: a triple A (AAA) is the highest credit quality, and C or D (depending on the agency issuing the rating) is the lowest or junk quality. Within this spectrum there are different degrees of each rating, which are, depending on the agency, sometimes denoted by a plus or negative sign or a number.
Thus, for Fitch Ratings, a "AAA" rating signifies the highest investment grade and means that there is very low credit risk. "AA" represents very high credit quality; "A" means high credit quality, and "BBB" is good credit quality. These ratings are considered to be investment grade, which means that the security or entity being rated carries a quality level that many institutions require when considering overseas investments.
Ratings that fall under "BBB" are considered to be speculative or junk. Thus for Moody's, a Ba2 would be a speculative-grade rating, while for S&P's, a "D" denotes default of junk bond status.
The following chart gives an overview of the different ratings symbols that Moody's and Standard & Poor's issue:
Sovereign Credit Ratings
As previously mentioned, a rating can refer to an entity's specific financial obligation or to its general credit worthiness. A sovereign credit rating provides the latter, as it signifies a country's overall ability to provide a secure investment environment. This rating reflects factors such as a country's economic status, transparency in the capital market, levels of public and private investment flows, foreign direct investment, foreign currency reserves, political stability, or the ability for a country's economy to remain stable despite political change.
Because it is the doorway into a country's investment atmosphere, the sovereign rating is the first thing most institutional investors will look at when deciding whether to invest money abroad. This rating gives the investor an immediate understanding of the risk level associated with investing in the country. A country with a sovereign rating will therefore get more attention than one without. So to attract foreign money, most countries will strive to obtain a sovereign rating, and they will strive even more to reach investment grade. In most circumstances, a country's sovereign credit rating will be its upper limit of credit ratings.
While the rating agencies provide a robust service, the value of such ratings has been widely questioned since the 2008 financial crisis. A key criticism is that the issuers themselves pay the credit ratings agencies to rate their securities. This became particularly important as the surging real estate market reached its peak in 2006-2007, and more and more subprime debt was making its way to the ratings agencies. The potential to earn high fees created competition between the three major agencies to issue the highest ratings possible. When the housing market began to collapse in 2007-2008, ratings firms were disastrously late in downgrading those top-notch ratings to reflect present-day reality.
To help resolve the potential conflicts of interest of the credit rating agencies, the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act mandated improvements to regulating credit rating agencies. Under the rules, credit rating agencies have to publicly disclose how their ratings have performed. They are also held liable for ratings that they should have known were inaccurate. In 2013, Standard & Poor's, Moody's and Fitch Ratings were sued for assigning artificially high credit ratings to the mortgage bonds held in a Bear Stearn's hedge fund.
Any good investment firm, whether it's a mutual fund, bank or hedge fund, will not rely solely on the bond rating agency's rating and will supplement its research with that from its in-house research department. That is why it's important for an individual investor to not only question the initial bond rating, but frequently review the ratings over the life of a bond and constantly question those ratings as well.
The Bottom Line
A credit rating is a useful tool not only for the investor, but also for the entities looking for investors. An investment-grade rating can put a security, company or country on the global radar, attracting foreign money and boosting a nation's economy. Indeed, for emerging market economies, the credit rating is key to showing their worthiness of money from foreign investors. And because the credit rating acts to facilitate investments, many countries and companies will strive to maintain and improve their ratings, hence ensuring a stable political environment and a more transparent capital market.