Credit ratings provide retail and institutional investors with information that assists them in determining whether issuers of bonds and other debt instruments and fixed-income securities will be able to meet their obligations.
When they issue letter grades, credit rating agencies (CRAs) provide objective analyses and independent assessments of companies and countries that issue such securities. Here is a basic history of how the ratings and the agencies developed in the U.S. and grew to aid investors all over the globe.
- Credit rating agencies provide investors with information about whether bond and debt instrument issuers can meet their obligations.
- Agencies also provide information about countries' sovereign debt.
- The global credit rating industry is highly concentrated, with three agencies: Moody's, Standard & Poor's, and Fitch.
- CRAs are regulated at several different levels—the Credit Rating Agency Reform Act of 2006 regulates their internal processes, record-keeping, and business practices.
- The agencies came under heavy scrutiny and regulatory pressure because of the role they played in the financial crisis and Great Recession.
An Overview of Credit Ratings
Countries are issued sovereign credit ratings. This rating analyzes the general creditworthiness of a country or foreign government. Sovereign credit ratings take the overall economic conditions of a country into account, including the volume of foreign, public and private investment, capital market transparency, and foreign currency reserves. Sovereign ratings also assess political conditions such as overall political stability and the level of economic stability a country will maintain during times of political transition. Institutional investors rely on sovereign ratings to qualify and quantify the general investment atmosphere of a particular country. The sovereign rating is often the prerequisite information institutional investors use to determine if they will further consider specific companies, industries, and classes of securities issued in a specific country.
Credit ratings, debt ratings, or bond ratings are issued to individual companies and to specific classes of individual securities such as preferred stock, corporate bonds, and various classes of government bonds. Ratings can be assigned separately to both short-term and long-term obligations. Long-term ratings analyze and assess a company's ability to meet its responsibilities with respect to all of its securities issued. Short-term ratings focus on the specific securities' ability to perform given the company's current financial condition and general industry performance conditions.
The Big Three Agencies
The global credit rating industry is highly concentrated, with three agencies—Moody's, Standard & Poor's, and Fitch—controlling nearly the entire market. Together, the provide a much-needed service for both borrowers and lenders, as well as to lenders. They intend to give the market information that is both reliable and accurate about the risks associated with certain kinds of debt.
Fitch is one of the world's top three credit rating agencies. It operates in New York and London, basing ratings on company debt and its sensitivity to changes like interest rates. When it comes to sovereign debt, countries request Fitch—and other agencies—to provide an evaluation of their financial situation along with the political and economic climates.
Investment grade ratings from Fitch range from AAA to BBB. These letter grades indicate no to low potential for default on debt. Non-investment grade ratings go from BB to D, the latter meaning the debtor has defaulted.
John Knowles Fitch founded the Fitch Publishing Company in 1913, providing financial statistics for use in the investment industry via "The Fitch Stock and Bond Manual" and "The Fitch Bond Book." In 1923, Fitch introduced the AAA through D rating system that has become the basis for ratings throughout the industry. With plans to become a full-service global rating agency, in the late 1990s Fitch merged with IBCA of London, subsidiary of Fimalac, a French holding company. Fitch also acquired market competitors Thomson BankWatch and Duff & Phelps Credit Ratings. Fitch began to develop operating subsidiaries specializing in enterprise risk management, data services, and finance-industry training starting in 2005 with the acquisition of a Canadian company, Algorithmics, and the creation of Fitch Solutions and Fitch Training (now Fitch Learning).
Moody's Investors Service
Moody's assigns countries and company debt letter grades, but in a slightly different way. Investment grade debt goes from Aaa—the highest grade that can be assigned—to Baa3, which indicates that the debtor is able to pay back short-term debt. Below investment grade is speculative grade debt, which are 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. The manual published basic statistics and general information about stocks and bonds of various industries. From 1903 until the stock market crash of 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, which, in the following 10 years, would provide ratings for nearly all of the government bond markets at the time. By the 1970s Moody's began rating commercial paper and bank deposits, becoming the full-scale rating agency it is today.
Standard & Poor's
S&P has a total of 17 ratings it can assign to corporate and sovereign debt. Anything rated AAA to BBB- is considered investment grade, meaning it has the ability to repay debt with no concern. 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 being 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 formed in 1906, which published corporate bond, 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. Standard and Poor's has become best known by indexes such as the S&P 500, a stock market index that is both a tool for investor analysis and decision-making, and a U.S. economic indicator.
Nationally Recognized Statistical Rating Organizations
The credit ratings industry began to adopt some important changes and innovations in 1970. Investors subscribed to publications from each of the ratings agencies and issuers paid no fees for performance of research and analyses that were a normal part of the development of published credit ratings. As an industry, credit ratings agencies began to recognize that objective credit ratings significantly helped issuers: They 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 ratings 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 by one or more of the NRSROs. This allowance is the result of registration requirements coupled with greater regulation and oversight of the credit ratings industry by the SEC. The increased demand for ratings services by investors and securities issuers, combined with increased regulatory oversight, has led to growth and expansion in the credit ratings industry.
Regulation and Legislation
Since large CRAs operate on an international scale, regulation occurs at several different levels. Congress passed the Credit Rating Agency Reform Act of 2006, allowing the SEC to regulate the internal processes, record-keeping, and certain business practices of CRAs. 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.
Credit rating agencies are regulated at several different levels.
The European Union (EU) has never produced a specific or systematic legislation or created a singular agency responsible for the regulation of CRAs. There are several EU directives, such as the Capital Requirements Directive of 2006, that affect rating agencies, their business practices and their disclosure requirements. Most directives and regulations are the responsibility of the European Securities and Markets Authority.
The Financial Crisis
Credit rating agencies came under heavy scrutiny and regulatory pressure following the financial crisis and Great Recession of 2007 to 2009. It was believed that CRAs provided ratings that were too positive, leading to bad investments. Part of the problem was that despite the risk, the agencies continued to give mortgage-backed securities (MBSs) AAA-ratings. These ratings led many investors to believe that these investments were very safe with little to no risk.The agencies were accused of trying to raise profits as well as their market share in exchange for these inaccurate ratings. This helped lead to the subprime mortgage market collapse that led to the financial crisis.
To add fuel to the fire, the agencies' European sovereign debt ratings were also cause for scrutiny. After the calamity caused by the debt crisis of several European countries including Greece and Portugal, the agencies downgraded the ratings of other nations in the EU.
Some have argued that regulators have helped to prop up an oligopoly in the credit rating industry, providing rules that act as barriers to entry for small- or mid-sized agencies. New rules in the EU have made CRAs liable for improper or negligent ratings that cause damage to an investor.
The Bottom Line
Investors may utilize information from a single agency or from multiple rating agencies. Investors expect credit rating agencies to provide objective information based on sound analytical methods and accurate statistical measurements. Investors also expect issuers of securities to comply with rules and regulations set forth by governing bodies, in the same respect that credit rating agencies comply with reporting procedures developed by securities industry governing agencies.
The analyses and assessments provided by various credit rating agencies provide investors with information and insight that facilitates their ability to examine and understand the risks and opportunities associated with various investment environments. With this insight, investors can make informed decisions as to the countries, industries, and classes of securities in which they choose to invest.