Before you decide whether to invest in a bond or 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 agency helps to determine the likelihood of default for the bond.

A credit ratings company helps investors decide how risky it is to invest money in a certain country or security by providing independent, objective assessments of the creditworthiness of companies and countries.

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 domestic market. It is important to gain insight into different investment environments and to understand the risks and advantages these environments pose. Credit ratings are essential tools for helping you make investment decisions.

The Raters

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 that are issued by a government or a corporation including banks and insurance companies among others.

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

For long-term issues or instruments, the ratings lie on a spectrum ranging from the highest credit quality on one end to default or "junk" on the other. 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 a satisfactory 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.

In other words, BBB is the lowest rating of investment grade securities while ratings below "BBB" are considered speculative or junk. Thus for Moody's, a Ba would be a speculative or low-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:

Bond Rating      
Moody's Standard & Poor's Grade Risk
Aaa AAA Investment Lowest Risk
Aa AA Investment Low Risk
A A Investment Low Risk
Baa BBB Investment Medium Risk
Ba, B BB, B Junk High Risk
Caa/Ca/C CCC/CC/C Junk Highest Risk
C D Junk In Default

Sovereign Credit Ratings

As previously mentioned, a rating can refer to an entity's specific financial obligation or its general creditworthiness. 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 markets, 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.

A sovereign credit rating is an indication of the viability of a country's investment markets, and as a result, is typically the first metric that most institutional investors look at before investing internationally. The rating provides investors with the risk level associated with investing in the country. Most countries strive to obtain a sovereign rating including investment grade to attract foreign investment.

Controversies

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 peaked in 2006-2007, a significant amount of subprime debt was being rated by the 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 or bank, whether it manages a mutual fund, hedge fund, or offers wealth management services to its clients will not rely solely on a bond rating from a credit agency to determine if an investment is safe. Typically, the in-house research department will help make the determination, which is why it's important for investors to perform research and due diligence by questioning the initial bond rating and frequently reviewing the ratings for any changes over the life of the investment.

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 help a security, company, or country attract both domestic and foreign investment. For emerging market economies, a solid credit rating is critical to demonstrating their creditworthiness to foreign investors. Also, a better rating typically means a lower interest rate, reducing the chances of default in a rising rate environment.