Credit Rating Agencies

Updated on January 5, 2024
Article byPrakhar Gajendrakar
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Are Credit Rating Agencies?

Credit rating agencies (CRAs) evaluate and rate the creditworthiness of debt securities and their issuers, including companies and countries. These agencies assign credit risk ratings to such entities based on quantitative and qualitative analyses. Ratings show the likelihood of a borrower to default or repay a loan with interest.

Credit rating services use unique letter codes to depict the default risk and the financial stability of the debt issuer. While these ratings provide risk measures for an entity, investors get to know about its creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more. Besides corporations and nations, these ratings can be for stocks, bonds, mortgage-backed securitiesMortgage-backed SecuritiesA mortgage-backed security (MBS) is a financial instrument backed by collateral in the form of a bundle of mortgage loans. The investors are benefitted from periodic payment encompassing a specific percentage of interest and principle. However, they also face several risks like default and prepayment risks.read more, collateralized debt obligations, and credit default swaps.

Key Takeaways

  • Credit rating agencies assess and rate the creditworthiness of fixed-income securities and debt obligations of their issuers. Ratings indicate the likelihood of an enterprise or the government defaulting on debt or repaying it with interest.
  • The rating services assign letters to represent the risk of default and financial viability of the debt issuer, based on quantitative, qualitative, and contextual analyses.
  • Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings are the 3 big credit rating agencies, with a combined market share of approximately 95%.
  • The United States Office of Credit Rating monitors, regulates, and governs CRAs.

How Do Credit Rating Agencies Work?

Credit rating agencies evaluate and rate companies, nations, governments, or financial instrumentsFinancial InstrumentsFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.read more. They essentially provide information about the quality of fixed-income securities and debt obligations and their issuers’ ability to repay the principal amount and interests. In short, these credit risk ratings help retail and institutional investorsInstitutional InvestorsInstitutional investors are entities that pool money from a variety of investors and individuals to create a large sum that is then handed to investment managers who invest it in a variety of assets, shares, and securities. Banks, NBFCs, mutual funds, pension funds, and hedge funds are all examples.read more get an idea of the solvencySolvencySolvency of a company means its ability to meet the long term financial commitments, continue its operation in the foreseeable future and achieve long term growth. It indicates that the entity will conduct its business with ease.read more of the borrower and its products. They can decide whether the security in question is worth the investment or just speculationSpeculationA speculator is an individual or financial institution that places short-term bets on securities based on speculations. For example, rather than focusing on the long-term growth prospects of a particular company, they would take calculated risks on a stock with the potential of yielding a higher return.read more.

Credit Rating Agencies

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The credit rating agencies meaning is that these services collect financial informationFinancial InformationFinancial Information refers to the summarized data of monetary transactions that is helpful to investors in understanding company’s profitability, their assets, and growth prospects. Financial Data about individuals like past Months Bank Statement, Tax return receipts helps banks to understand customer’s credit quality, repayment capacity etc.read more for loans and insurance, perform quantitative, qualitative, and contextual analyses, and assess the borrower’s ability to repay the debt.

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These services charge a fee in exchange for rating an entity (business and nation) or providing a rating for use by an entity (banks and financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more). And for that reason, they are criticized for giving good ratings to issuers that pay them. Therefore, the United States enacted the Credit Rating Agency Reform Act in 2006 to regulate these agencies.

These agencies assign letter codes and symbols to entities and instruments, such as AA, BB, AAA, A+, B-, etc. The higher the rating (AAA) of a security, the most lucrative investment it is, and the lower the rating (C or D), the more speculative it will be.

It is also worth noting that these codes do not serve as investment advice but as a factor determining the ability of the issuer to meet its obligations. The debt issuers may range from companies to countries, municipal to state governments, and special-purpose institutions to non-profits. Standard & Poor’s, Moody’s, and Fitch are the 3 big credit rating agencies, with a combined market shareMarket ShareMarket share determines the company's contribution in percentage to the total revenue generated within an industry or market in a certain period. It depicts the company's market position when compared to that of its competitors.read more of roughly 95%.

History Of Credit Rating Agencies

In the mid-1970s, mortgage-backed securities (MBS) were the first to receive such ratings. However, credit rating services later began assigning codes to other asset-backed securities.

During the 2008 financial crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more, the US credit rating agencies rated debts like MBS higher, which proved to be risky investments and later resulted in defaults and loss of investors’ confidence. Experts criticized these agencies for failing to recognize investment risksInvestment RisksInvestment risk is the probability or uncertainty of losses rather than expected profit from investment due to a fall in the fair price of securities such as bonds, stocks, real estate. In addition, each type of investment is prone to some degree of investment or default risk.read more. Furthermore, security issuers bribed rating services to obtain a good credit score.

These agencies are now more specific, accurate, and efficient in providing the appropriate credit scores to entities and debt instrumentsDebt InstrumentsDebt instruments provide finance for the company's growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans.read more. It has been possible due to increased oversight, regulations, policies, and governance by the U.S. Office of Credit Ratings.

What Do Credit Ratings Say?

Credit rating meaning differs with entities and financial instruments, though they evaluate issuers’ credit or default risksDefault RisksDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.read more and debt obligations. For example, a company can use it to rate its debt securities, while a country can use the same to attract domestic and foreign investmentsForeign InvestmentsForeign investment refers to domestic companies investing in foreign companies in order to gain a stake and actively participate in the day-to-day operations of the business, as well as for essential strategic expansion. For example, if an American company invests in an Indian company, it will be considered a foreign investment.read more. Ratings for sovereign debts indicate the country’s ability to repay its debt. Also, a sovereign credit rating facilitates access to international financial markets for the government.

Similarly, a bank can use it to assess the risk premiumRisk PremiumRisk Premium, also known as Default Risk Premium, is the expected rate of return that the investors receive for their high-risk investment. You can calculate it by deducting the Risk-Free Investment Return from the Actual Investment Return. read more on loans. Poorly rated loans have a higher risk premium and higher interest rates. A higher credit rating enables the borrower to obtain loans at a lower interest rate. Credit ratings allow traders to trade fixed-income on the secondary marketSecondary MarketA secondary market is a platform where investors can easily buy or sell securities once issued by the original issuer, be it a bank, corporation, or government entity. Also referred to as an aftermarket, it allows investors to trade securities freely without interference from those who issue them.read more and influence their interest rates – a higher grade gets a lower interest rate.

Credit risk ratings indicate the likelihood of a borrower defaulting on its obligation. While low risk suggests investment, high risk implies speculation. Furthermore, these scores provide an outlook for an issuer or financial product in the future. Also, these scores aid in the development of the financial marketFinancial MarketThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more and its regulations.

Role Of Credit Rating Agencies

The primary role of credit rating services is to assess the credit risks and solvency of structured debt securities and their issuers, i.e., companies and governments. Since they also act as financial intermediariesFinancial IntermediariesA financial intermediary refers to a third-party, forming environment for conducting financial transactions between different parties.read more, there are multiple objectives that they fulfill, such as:

Role Of Credit Rating Agencies

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  1. Lower information costs, attract potential borrowers and foster liquid markets
  2. Boost the supply of risk capital and economic growthEconomic GrowthEconomic growth refers to an increase in the aggregated production and market value of economic commodities and services in an economy over a specific period.read more
  3. Assist in structured financial transactions of securities backed by assets, residential and commercial mortgages, and collateralized debt obligationsCollateralized Debt ObligationsCollateralized debt obligation (CDO) refers to a finance product offered by the banks to the institutional investors. Such tranches have a complex structure and derive their value from the various underlying assets like loans, mortgages and corporate bonds, which also serve as collaterals in case of default.read more and derivatives
  4. Evaluate assets underlying the security and focus on the capital structureCapital StructureCapital Structure is the composition of company’s sources of funds, which is a mix of owner’s capital (equity) and loan (debt) from outsiders and is used to finance its overall operations and investment activities.read more
  5. Provide ratings for sovereign debtors, including municipalities, governments, and transnational entities backed by a sovereign state
  6. Help investors make well-informed decisions about an investment by providing insights into risks and rewards associated with it
  7. Provide credit scores to companies, governments, and debt obligations
  8. Encourage entities to pay on time and clear off their dues regularly to avoid a decrement in their credit scores, which eventually help them take loans and debtsDebtsDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state.read more in the financial markets
  9. Enable nations and states to sell bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more to investors in domestic and international markets

List Of Top Credit Rating Agencies

The credit rating services provide lenders and borrowers with accurate information about the risks and opportunities associated with debt. Several agencies function internationally. With a combined market share of about 95%, Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings are the three most well-known international credit rating agencies. Here is how they work:

#1 – Fitch Ratings

Fitch Ratings is an international credit rating agency established in 1923 and operating in New York and London, England. The company analyzes debts and the interest rate sensitivity they hold. It considers the politico-economic situations of a nation before assessing its sovereign debtSovereign DebtSovereign debt is the money borrowed by a country’s central government, primarily achieved by selling government bonds and securities. Treasury notes, bonds, and bills are some examples of sovereign debt issued by the United States.read more.

The agency uses a letter-based scoring system, with AAA, AA, A, and BBB representing investment grade and BB, B, CCC, CC, C, DDD, DD, and D showing non-investment class. For example, AAA rating denotes the high value of an entity or security, while D rating signifies a greater risk of defaulting on a loan. Many investors trust ratings provided by Fitch to distinguish investments that will not default and present significant returns.

#2 – Moody’s Investors Service

Another credit rating service, Moody’s Investors Service, created in 1909, offers investors financial information on bonds issued by firms and governments. The company is well-known for its business analysis, risk assessment, and investment services.

When assessing debts, the agency employs a unique letter system for debt securities, with investment gradesInvestment GradesInvestment grade is the credit rating of fixed-income bonds, bills, and notes as assigned by the credit rating agencies like Standard and Poor’s (S&P), Fitch, and Moody’s to express the creditworthiness of and risk associated with these investments.read more ranging from Aaa to Baa3, indicating the debtor’sDebtor'sA debtor is a borrower who is liable to pay a certain sum to a credit supplier such as a bank, credit card company or goods supplier. The borrower could be an individual like a home loan seeker or a corporate body borrowing funds for business expansion. read more ability to repay, and speculative classes ranging from Ba1 to C, indicating the issuer’s risk of default.

The firm undertakes open research in collaboration with large multinational corporations and local governments. Moody’s assessments have long been trusted for their market insights and understanding of the market volatility while also providing a global perspective on debt markets.

#3 – Standard & Poor’s

Standard and Poor’s has been assigning ratings to bondsRatings To BondsBond rating refers to how designated agencies classify fixed income securities in order to help investors identify the security's future potential. After researching the issuer's financial standing, including growth prospects and upcoming corporate actions, ratings are assigned.read more of companies and government since 1941. The firm is well-known as a data provider for investment benchmarks. It has a comprehensive rating system with 17 letter-based scores.

It assigns AAA to BBB ratings to investment-grade debts with the potential to repay and BB+ to D ratings to speculative-grade loans with higher credit risksCredit RisksCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more. Simply put, a higher credit rating assures investors that the issuer will not fail on its loans.

Frequently Asked Questions (FAQs)

What do credit rating agencies mean?

Credit rating services codify businesses, nations, governments, and financial instruments. They essentially give data on the quality of fixed-income securities and debt obligations and their issuers’ capacity to repay principal loans and interest. These agencies use letter codes and symbols, such as AA, BB, AAA, A+, B-, etc. The higher a security rating (AAA), the more profitable it is, and the lower the grade (C or D), the more speculative it is. While these ratings give risk metrics for a company, they also inform investors about the borrower’s creditworthiness.

Who regulates credit rating agencies?

The United States Office of Credit Ratings is responsible for monitoring and regulating credit rating services. Also, the Credit Rating Agency Reform Act of 2006 controls these companies.

Who pays credit rating agencies?

A credit rating agency gathers financial data for loans and insurances, does quantitative, qualitative, and contextual research, and determines the borrower’s ability to repay the debt. However, these services charge a fee in exchange for rating an entity (company and nation) or providing a rating for use by an entity (banks and financial institutions).

This article has been a Guide to Credit Rating Agencies and its Meaning. Here we discuss the top credit rating agencies, their history, how they work, and their roles. You may learn more about financing from the following articles –

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