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Standard & Poor’s, Moody’s and Fitch. They may sound like something out of a Harry Potter novel, but these rating agencies have an important role in the real world: rating the creditworthiness of companies, countries, local governments and more. This shouldn’t be confused with the (separate) business of assessing the creditworthiness of individuals and producing credit scores.
They are most closely associated with helping investors in bond markets to assess the quality of debt. By conducting heaps of research, rating agencies develop a view of how risky an investment is.
The agencies use a letter-based system to indicate the level of default risk. The idea is that investors thinking of lending money to governments or corporations (by buying their bonds) can see at a glance how likely they are to get their money back.
The best rating, given to debt which is most likely to be repaid, is AAA. Next comes AA1, and the scale runs all the way down to D. Any rating below BBB is considered to be ‘junk’.
Junk debt, often in the form of junk bonds, carries a higher risk of default. For this reason, the interest rate on junk bonds also tends to be higher: otherwise, there wouldn’t be much incentive for investors to take on something this risky.
And the opposite is true for ‘investment grade’ debt, rated from AAA-BBB: because the rating agency believes the chances are better that the loan will be repaid in full, interest rates tend to be lower.
This explains why ratings are just as important to companies and governments as they are to investors. The rating they’re awarded will determine how easy it is to attract investors, and how cheaply they’ll be able to borrow money from them. It can be seriously bad news for a country if its debt is downgraded and it can even give international markets the jitters.
Credit rating overrated?
But they’re not infallible. Infamously, they gave AAA ratings to debt derived from ‘sub-prime’ mortgages. The discovery that this debt was actually quite likely to default triggered the global financial crisis of 2007/8. The Big Three also previously failed to spot crises at firms, such as Enron and WorldCom. Only days before these companies went up in smoke, their debt was still classed as ‘investment grade’.
Mistakes such as these have caused the ratings agencies to be criticised, even if they get it right most of the time.
What about the other rating agencies?
The Big Three may hog the limelight, but there are plenty of other rating agencies – and they don’t confine themselves to rating the quality of debt. For example, there are agencies assessing the quality of investment funds and stocks. Here, Lipper is popular with financial journalists while Morningstar and Trustnet also appeal directly to consumers. There are others too: indeed there are more than 150 rating agencies worldwide, each specialising in different types of investments and using different measurements and methods to arrive at their ratings.
AAA, Ba3, Ca, CCC... they look like some kind of hyper-active school report. They are, indeed, a marking system.
Corporate bonds can and do default. The probability of a bond default is strongly reflected in the credit rating assigned to the bond by the rating agencies.
Starting in 1909, a dense book from John Moody would thud on to subscribers' desks in America, following days or even weeks in the post.