Since the early 20th century, credit rating agencies have been providing essential services to the global financial system by assigning ratings to bonds and other debt instruments based on their perceived safety and reliability.
Investors can have a far clearer picture of whether or not a given debt instrument is a good bet thanks to these ratings. It follows that bond investors will typically check the issuer’s credit rating to determine the level of risk associated with a bond.
Bonds with lower credit ratings will often have a higher interest rate demanded by investors due to the tradeoff between risk and return. Thus, rating organizations are crucial in establishing the rates of interest attached to debt securities.
What Credit Rating Agencies Do
Companies and governments of all stripes receive credit ratings from the same credit rating organizations because they all issued debt instruments like bonds. The credit rating industry is crucial to bond markets and the financial industry as a whole because investors need to know they are being compensated adequately for the risk they are taking by holding an investment.
There is a correlation between a debt’s perceived riskiness and the interest rate it carries. Debt with a higher risk of default attracts a higher interest rate. Short-term bonds typically offer lower interest rates than their longer-term counterparts since investors only have to commit their capital for a shorter period of time and there is thus less risk involved.
Credit ratings are crucial to the interest rates of various debt products such as bonds and commercial paper because investors use the judgments of rating organizations as measurements for the level of risk associated with debt.
Credit Rating Agency History
In the early 20th century, three prominent credit rating organizations were established, pioneering the practice of utilizing rating agencies to evaluate the safety of a given debt. Although other rating agencies have emerged since the 1960s, Fitch, Moody’s, and Standard & Poor’s (S&P) continue to dominate the industry.
These businesses have evolved into what the United States calls Nationally Recognized Statistical Rating Organizations (NRSROs). In other words, the Securities and Exchange Commission has granted them permission to distribute credit rating information to institutional investors and other market participants.
1. Fitch
John Knowles Fitch, an entrepreneur at the age of 33, started the Fitch Publishing Company after inheriting his father’s printing firm in 1913. Fitch’s original vision for his firm was to distribute stock and bond market data to the public.
In 1924, Fitch developed a system for grading financial instruments based on a corporation’s ability to repay its obligations, thereby expanding the services offered by its organization.
Although Fitch’s method of assigning grades to financial instruments became the industry standard, the company is currently the smallest of the “big three” credit rating agencies.
2. S&P
John Henry Varnum The financial analyst Poor shared this outlook. Similar to Fitch, Poor founded the H.V. and H.W. Poor Company because he was interested in releasing economic data.
Another analyst who aspired to work for a financial publication was Luther Lee Blake. Just one year after Poor’s untimely demise, in 1906, Blake established Standard Statistics to realize his vision.
A lot of the same data may be found in the works of Standard Statistics and H.V. and H.W. Poor. For this reason, in 1941, Standard & Poor’s and the International Monetary Fund amalgamated to form a single corporation with a unified asset base.
Standard & Poor’s is now a one-stop-shop for financial services, providing ratings as well as other options including investment research. Of the big three, they are currently the largest.
3. Moody’s
Moody’s Investors Service, commonly shortened to Moody’s, is a financial holding firm that was created in 1909 by John Moody. Moody’s Investor Services is one of the company’s main divisions. Moody’s has been providing credit ratings ever since 1914, however, they were limited to government bonds until 1970.
Over time, Moody’s has expanded greatly. Among the big three, Moody’s is currently the second largest.
Workings of Credit Rating Agencies
Since most investors are unwilling to purchase unrated bonds, it is in the best interest of debtors to provide investors with a reliable assessment of the creditworthiness of their instruments. Therefore, if a bond issuer needs to raise capital, it must pay a credit rating agency to assess the safety of its bonds.
The credit rating agency will conduct a thorough analysis of the financial institution following the company’s request for proposals. However, there is no foolproof method for determining an institution’s credit rating; rather, the rating agency must undertake research and make an objective judgment as to whether or not the bond issuer is likely to repay the loan or is more likely to default.
Credit rating agencies evaluate an organization based on a number of criteria, such as its current debt load, its character, its financial liquidity, its track record of loan repayment, and its financial strength.
Many of these elements can be gleaned from the financial accounts and balance sheets of the institution in question, but others, like the mentality of the management toward debt, require closer examination.
A prime example is the 2011 national debt ceiling disaster, which resulted in a downgrading of the United States’ sovereign debt rating from AAA to AA+ by S&P.
One of the factors that bond rating firms consider when assigning a credit rating to a financial organization is how the debt is categorized.
- High grade
- Upper medium grade
- Lower medium grade
- Non-investment grade speculative
- Highly speculative
- Substantial risks or near default
- In default
The ratings are typically accompanied by a letter grade, such as AAA, BBB, or BB+. As a general rule, the term “junk bonds” is used to refer to bonds with a rating of BBB- or worse from credit rating agencies Fitch and Moody’s. These bonds carry a higher level of danger but also provide the highest possible profits.
The highest quality investments are the most reliable kind of debt financing. However, investments that are already in default are the most precarious forms of debt because they have proven they cannot meet their financial commitments. A far higher rate of return is necessary for defaulted investments if they want to attract any investors at all.
Pros of Credit Agencies
The work that credit bureaus conduct is beneficial in many ways.
1. They Assist Good Institutions in Obtaining Better Rates
Better credit allows institutions to borrow funds at lower interest rates. Responsible financial management and prompt debt repayment are rewarded under this system. As a result, their business can grow at a more rapid pace, which in turn boosts economic growth.
2. They Alert Consumers and Investors to Dangerous Businesses
Investors are usually interested in learning how much of a risk it takes to extend credit to a particular company. Investors in corporate bonds typically do so because they expect to receive principal and interest payments on their investments.
Many people decide whether or not to invest based on the level of risk they perceive, making rating agencies crucial. Before committing to an insurance provider, many customers research that organization’s financial stability. Inadequate financial resources mean insurance may default on a payout.
3. They Offer an Appropriate Risk-Return Ratio
Some investors are willing to take on more uncertainty by purchasing high-yielding debt assets. They are willing to accept risks, but only if they are assured of a favorable payoff.
Bond prices and yields are highly correlated, making it simple for buyers to select securities that correspond with their risk preferences and financial objectives.
In order to create a portfolio of extremely secure bonds, a mutual fund manager might, for instance, exclusively invest in bonds with the highest possible ratings. Bonds issued by corporations with lower ratings may be chosen by those seeking a higher-risk, higher-return investment strategy.
4. They Encourage Institutions to Improve
Institutions that have taken on too much debt or have not shown they are prepared to be responsible about paying it back may benefit from a wake-up call in the form of a bad credit rating. Until an analyst alerts them to possible concerns, these institutions will likely continue to ignore their credit problems.
Cons of Credit Rating Companies
Credit rating agencies have been useful in many ways, but they are not perfect.
1. Assessment Is Very Subjective
The process of assigning a credit rating to a financial institution is not governed by any universally accepted set of rules; rather, several rating techniques are used, each of which places a heavy emphasis on subjective judgment calls.
Unfortunately, they frequently end up making conflicting judgments, and credit scores from different agencies can vary. When the United States lost its AAA credit rating, for instance, the S&P downgrade garnered considerable attention.
The United States’ AAA rating was maintained by the other two major credit rating agencies notwithstanding the S&P downgrade.
2. Conflict of Interest Is Possible
Ratings from credit bureaus are typically requested by the institutions themselves. Although rating organizations will occasionally undertake unrequested examinations of firms and market the ratings to investors, they are typically funded by the companies themselves.
Discrepancies of interest are inevitable under such a framework. It’s possible that the rating agency would be tempted to give the company a higher rating in exchange for continuing to receive payment from the corporation.
Credit rating agencies have been investigated by the Department of Justice for their role in the 2008 financial crisis, and new regulations have been implemented to try to limit conflicts of interest and prevent another meltdown of the financial sector like the one that occurred during the subprime mortgage crisis.
As a result of these probes, in 2010, Congress passed the Dodd-Frank Act, which, among other reforms to the rules governing the financial system, granted regulators greater authority to monitor credit rating organizations.
3. Ratings May Not Always Be Reliable
Credit rating firms may provide a standard scale for ratings, but that doesn’t guarantee reliable assessments of businesses. It has been common practice to accept these agencies’ credit ratings without scrutiny for a long time.
Investors have lost faith in rating agencies after they gave AAA ratings to worthless mortgage-backed securities and collateralized debt obligations (CDOs) that exacerbated the Great Recession. Many people still look to them for guidance, but they no longer carry the same weight as they once did.
It’s interesting to note that when the United States debt was downgraded, investors flocked to U.S. treasuries in greater numbers than ever before, surprising the financial community. This was a telltale sign that they weren’t giving the advice of the credit rating organizations the weight that it deserved.
What About Credit Ratings for Consumers?
Individuals seeking loans are more likely to be familiar with consumer credit rating firms than are businesses and other major organizations. Individual credit ratings, like company credit ratings, are meant to help lenders assess the potential danger of lending money to a specific person.
In addition to a wider selection of better interest-rate loan offers, those with higher credit ratings also tend to have fewer loan restrictions placed upon them.
These credit bureaus compile data on consumers’ credit behaviors and assign each one a score based on that data. Those that make payments on time and don’t rack up excessive debt will have higher credit scores.
Customers can choose from three major credit reporting bureaus.
Equifax
The company that is now known as Equifax was started by Cator and Guy Woolford in 1899. Having started in Georgia, the corporation swiftly extended to other states and even Canada by 1920.
In 1960, Equifax was already a major player among American credit bureaus. It currently stores credit information for over 800 million people and 88 million businesses throughout the world.
While providing credit reports to lenders is Equifax’s main source of revenue, the company also provides some services to consumers on an individual basis, such as identity theft protection.
Experian
While the current iteration of Experian began in 1996, the company’s ancestors can be traced all the way back to the Credit Data Corporation. The current headquarters are in Dublin, Ireland, with other outposts in another 37 countries.
Records for about 1 billion individuals and companies are stored there, including over 235 million Americans and 25 million American corporations.
In addition to its rating services, Experian also provides businesses and political parties with marketing and analytics data. Using this data, we can reach the right people with our messages.
TransUnion
In 1968, in Chicago, TransUnion was established. Despite being the smallest of the three major credit agencies in the United States, it maintains data on more than 200 million Americans and partners with more than 65,000 organizations to distribute credit reports to consumers.
FICO
While it is not technically a credit bureau, Fair Isaac Corporation’s (FICO) contributions to the world of credit scoring for individual consumers cannot be overstated. The company was established in 1956 by Bill Fair and Earl Isaac, and its credit scoring algorithms are the most extensively utilized in the United States.
Credit bureaus typically use FICO’s methods and the information they have collected on individuals to assign them a numeric credit score. These ratings provide lenders with a fast snapshot of a borrower’s riskiness.
Lenders bought more than 10 billion FICO credit scores in 2013, demonstrating the widespread use of the company’s methods.
Bottom Line
Over the past century, credit rating agencies have been essential participants in the global financial system. They have been useful in determining appropriate interest rates because they have allowed investors to more accurately gauge the level of risk associated with a certain investment.
Still, it’s important to keep in mind that the opinions of rating agencies should be regarded with a grain of salt. Even though they represent the opinions of highly educated professionals, we should treat them as just that: opinions.
When deciding whether or not to invest in a debt instrument at a given price or interest rate, investors should take a credit rating into consideration, but ultimately rely on their own good judgment.
When deciding which security to invest in, it is important to weigh the company’s debt level, annual revenue, and cash on hand. While rating agencies do take this into account, investors should still draw their own conclusions about the security risk level.
