Credit rating agencies have been around since the early 20th century and have played a key role in the financial world by providing ratings on the creditworthiness of bonds and other debt instruments.
These ratings are invaluable tools for investors looking to get a better sense of whether a debt instrument is worth investing in. Therefore, when assessing the level of risk associated with a bond, investors will typically look at the issuer’s credit rating.
Because most investors are looking for a tradeoff between risk and return on their investments, they are typically going to demand a higher interest rate for bonds that have poorer credit ratings. As a result, rating agencies play an important role in determining interest rates on debt securities.
Purpose of Credit Rating Agencies
Credit rating agencies assign ratings to any organization that issues debt instruments such as bonds, including private corporations and all levels of government. Because investors need to know they are receiving adequate compensation for the risk they are taking by holding an investment, the credit rating industry is essential to bond markets and the financial industry as a whole.
The interest rate attached to a debt is related to its level of risk. Riskier debt requires a higher interest rate to attract investors. That’s one reason short-term bonds pay lower interest rates than long-term ones — investors lock up their money for a shorter term and there’s less time for things to go wrong.
Because investors use the opinions of rating agencies as metrics for the level of risk attached to debt, credit ratings play a key role in the interest rates of different debt securities like bonds and commercial paper.
History of Credit Rating Agencies
The concept of using rating agencies to assess the level of risk of a debt arose around the beginning of the 20th century when three major credit rating agencies were formed. Although additional rating agencies were formed in subsequent years, the original rating agencies — Fitch, Moody’s, and Standard & Poor’s (S&P) — have the largest market share.
Today, these companies are called Nationally Recognized Statistical Rating Organizations (NRSROs) in the U.S. That means they are approved by the Securities and Exchange Commission to provide information about credit ratings for institutional investors and other market participants to rely on.
The Fitch Publishing Company was founded in 1913 by John Knowles Fitch, a 33-year-old entrepreneur who had just taken over his father’s printing business. Fitch had a unique goal for his company: to publish financial statistics on stocks and bonds.
In 1924, Fitch expanded the services of his business by creating a system for rating debt instruments based on the company’s ability to repay its obligations. Although Fitch’s rating system of grading debt instruments became the standard for other credit rating agencies, Fitch is now the smallest of the “big three” firms.
Henry Varnum Poor was a financial analyst with a similar vision. Like Fitch, Poor was interested in publishing financial statistics, which inspired him to create H.V. and H.W. Poor Company.
Luther Lee Blake was another financial analyst interested in becoming a financial publisher. In order to achieve this dream, Blake founded Standard Statistics in 1906, just a year after Poor’s death. Standard Statistics and H.V. and H.W. Poor published similar information. Hence, it made sense for the two companies to consolidate their assets, and they merged in 1941 to form the Standard & Poor’s Corporation.
Today, Standard & Poor’s not only provides ratings but also offers other financial services, such as investment research, to investors. They are now the largest of the “big three” rating agencies.
John Moody founded the financial holding company Moody’s Investors Service, often just called Moody’s, in 1909. Although Moody’s provides a number of services, one of their largest divisions is Moody’s Investor Services. Although Moody’s has conducted credit ratings since 1914, they only conducted ratings of government bonds until 1970.
Moody’s has grown significantly over the years. Presently, Moody’s is the second-largest of the “big three” firms.
How Credit Rating Agencies Work
Debtors want investors to have a good idea of how creditworthy their securities are, because most won’t buy unrated bonds. This means if it wants to borrow money, a bond issuer pays a credit rating agency to rate their debt.
After the company solicits a bid, the credit rating agency will evaluate the institution as carefully as possible. However, there is no magic formula to determine an institution’s credit rating; the agency must instead conduct research and subjectively decide whether repayment of the debt is likely or if the bond issuer is more likely to default.
When conducting their assessment, the credit rating agencies look at a number of factors, including the institution’s existing level of debt, its character, its financial liquidity, a historical demonstration of its ability and willingness to repay loans, and its financial ability to repay its debt.
Although many of these factors are based on information found on the institution’s balance sheet and income statements, others — such as an attitude toward repaying debt — need to be scrutinized more carefully.
For example, in the 2011 national debt ceiling debacle, S&P downgraded the U.S. sovereign debt rating because it felt the political brinkmanship of the federal government was not consistent with the behavior of a AAA institution.
When they assess an institution’s credit rating, the bond rating agencies classify the debt as one of the following:
- High grade
- Upper medium grade
- Lower medium grade
- Non-investment grade speculative
- Highly speculative
- Substantial risks or near default
- In default
Usually, they also assign a letter grade, like AAA, BBB, or BB+. Bonds rated below BBB- on Fitch and Moody’s scales are typically called junk bonds. These bonds are high-risk but offer the highest returns.
High grade investments are considered the safest debt available. On the other hand, investments that are listed as in default are the riskiest debt instruments because they have already demonstrated that they are unable to repay their obligations. Hence, investments in default will need to offer a much higher interest rate if they intend for anyone to invest money in them.
Advantages of Credit Agencies
There are many benefits to the work that credit agencies do.
1. They Help Good Institutions Get Better Rates
Institutions with better credit quality are able to borrow money at more favorable interest rates. Accordingly, this rewards organizations that are responsible about managing their money and paying off their debt. In turn, they will be able to expand their business at a faster rate, which helps stimulate the economy’s expansion as well.
2. They Warn Investors and Consumers of Risky Companies
Investors always want to know the level of credit risk associated with lending to a company. Few people would buy a corporate bond unless they believed there’s a good chance they’ll get their money back. This makes rating agencies important because many people base their investment decisions on the potential risk.
Many consumers also look at the credit rating of insurance companies before buying insurance. If the insurer has poor credit, it might not be able to pay out on a policy as promised.
3. They Provide a Fair Risk-Return Ratio
Not all investors are opposed to buying risky debt securities. However, they want to know that they are going to be rewarded if they take on a high level of risk. Because credit ratings and interest rates are closely tied, it makes it easy for investors to choose bonds that fit their investing goals and risk tolerance.
For example, a mutual fund manager looking to build a fund of incredibly safe bonds may only buy high grade bonds with top ratings. One who wants to build a portfolio with more risk but higher returns may choose bonds from companies with lower ratings.
4. They Give Institutions an Incentive to Improve
A poor credit rating can be a wake-up call for institutions that have taken on too much debt or haven’t demonstrated that they are willing to be responsible about paying it back. These institutions are often in denial of their credit woes and need to be alerted of potential problems from an analyst before they make the necessary changes.
Disadvantages of Credit Rating Agencies
Unfortunately, although credit rating agencies serve a number of purposes, they are not without flaws.
1. Evaluation Is Highly Subjective
There are no standard formulas to establish an institution’s credit rating; instead, credit rating agencies use different rating methodologies which rely heavily on judgment calls.
Unfortunately, they often end up making inconsistent judgments, and the ratings between different credit rating agencies may vary as well.
For example, there was much talk about the S&P downgrade when the United States lost its AAA credit rating. Regardless of the S&P decision, the other two major credit rating agencies gave the U.S. a different rating, maintaining it at the highest possible level.
2. There Can Be Conflict of Interest
The credit rating agencies usually provide ratings at the request of the institutions themselves. Although they sometimes conduct unsolicited evaluations on companies and sell the ratings to investors, the agencies usually are paid by the very companies they are rating.
Obviously, this system can lead to potential conflicts of interest. Because the company pays the rating agency to determine its rating, that agency might be inclined to give the company a more favorable rating to retain its business.
The Department of Justice has investigated the credit rating agencies for their role in the 2008 financial crisis and made regulatory changes to try to reduce these conflicts of interest and prevent another collapse of the financial system like there was during the subprime mortgage crisis.
Congress passed the 2010 Dodd-Frank Act in response to these investigations, which — among other financial system rule changes— gave regulators more power to oversee credit rating agencies and their activities.
3. Ratings Aren’t Always Accurate
Although credit rating agencies offer a consistent rating scale, that does not mean that companies are going to be rated accurately. For many years, the credit ratings of these agencies were rarely questioned.
However, after rating agencies provided AAA ratings for the worthless tranches of mortgage-backed securities and collateralized debt obligations (CDOs) that contributed to the Great Recession, investors don’t have nearly as much faith in them. Their ratings are still referenced by almost everyone, but their credibility has taken a serious hit.
Interestingly, when the U.S. had its debt downgraded, the financial community was surprised that more investors flocked to U.S. treasuries than ever before. This was a clear sign that they weren’t taking the credit rating agencies’ opinions as seriously as analysts would have expected.
What About Consumer Credit Ratings?
Many people are likely more familiar with the consumer credit rating agencies that focus on individuals rather than businesses and other large organizations that want to borrow money.
Like credit ratings for businesses, individual credit ratings are designed to help financial institutions determine the risk of making a loan to a person. People with higher ratings can command lower interest rates and will qualify for more loans than people with damaged credit.
These credit bureaus collect information on how people interact with credit, then use that information to generate a credit score. People who use credit responsibly will have better scores than people who miss payments or borrow too much money.
There are three major credit scoring agencies for consumers.
Equifax was founded in 1899 by Cator and Guy Woolford. The company expanded quickly from its Georgia roots and had offices throughout North America by 1920.
Equifax was one of the largest credit bureaus in the U.S. by 1960. Today, it has credit records for more than 800 million consumers and 88 million businesses around the world. Equifax’s primary business model is selling credit information to lenders, but also offers some services directly to consumers, including identity theft protection services.
Experian was founded in 1996 but has roots going farther back as the Credit Data Corporation. Today the company is based in Dublin, Ireland, and has offices in 37 countries around the world. It has credit records for more than 1 billion people and businesses, including 235 million individuals and 25 million businesses in the U.S.
Beyond its rating business, Experian sells analytic and marketing information to organizations including businesses and political parties. This information can help with targeted advertising and outreach.
TransUnion was founded in Chicago in 1968. It is the smallest of the three major credit bureaus in the U.S. but has records on more than 200 million Americans and works with more than 65,000 businesses to provide consumer credit reports.
Fair Isaac Corporation (FICO) isn’t a credit bureau but it plays an incredibly important role in consumer credit scoring. The company was founded by Bill Fair and Earl Isaac in 1956 and it is responsible for the most widely used consumer credit scoring models in the United States.
Credit bureaus generally use the information they’ve collected on consumers in concert with FICO’s formulas to generate numeric credit scores for consumers. These scores give lenders a quick sense of how risky a particular borrower is.
In 2013, lenders purchased more than 10 billion credit scores that used a FICO scoring model, showing the popularity of its formulas.
Pro tip: If you’re hoping to increase your credit score, sign up for a free Experian Boost account. Once signed up they’ll use payment history from your cell phone, internet, and streaming services to instantly boost your credit scores.
Credit rating agencies have played a significant role in the financial markets over the past century. Throughout their existence, they have helped investors identify the risk of an investment, making it easier to determine fair interest rates.
However, at the end of the day, rating agencies’ evaluations need to be taken with a grain of salt. Although their opinions are those of highly educated professionals, they are still opinions.
Investors should take a credit rating under advisement, but they should also use their own judgment when they decide whether to purchase a debt instrument at a certain price or interest rate. If you are investing in a security, consider how much debt the firm holds, its revenue, and the assets it has withstanding. Although these are some of the same factors a rating agency considers, investors should come to their own conclusion on the level of investment risk associated with a security.