When investing in bonds, the most important question to consider is, “will I get my money back?” A high coupon rate or yield doesn’t really matter much if the bond issuer defaults. But few individual investors have the time, effort, and expertise needed to do the detailed analysis required to assess an issuer’s financial health.
While professional asset managers and insurance companies that hold large portfolios of bonds often have teams of credit analysts to assess a bond issuer’s financial condition, many investors rely primarily on ratings of credit quality assigned by independent firms, known as credit rating agencies.
What is a Credit Rating Agency?
Rating agencies assign credit ratings based on their view of the likelihood that a borrower (a corporation, bank, government entity, or some other entity) might fail to make timely payments of interest and principal as promised on a security it issued in the capital markets.
Why are rating agencies useful?
Credit rating agencies provide a valuable service to both investors and issuers. Without their ratings:
- Every investor would have to do his/her own credit risk analysis before buying any bond. It would take time and resources to gain a sufficient understanding of the borrower’s business outlook, industry, and financial condition. This would limit the number of bonds any investor would be able to consider (there is only so much time in the day).
- Corporations, governments, and others that want to borrow in the capital markets would have to spend more time educating investors about their business, industry, financial condition, and so on. That would likely limit the number of investors a given borrower would attract, reducing the demand for its bonds. Issuers would probably have to offer a higher coupon rate on their bonds to get investors’ attention, thus increasing their cost of borrowing.
Many institutional investors (pension funds, insurance companies, and others) have policies that specify the credit quality of bonds they are allowed to buy, defined by the ratings the credit rating agencies assign. Often, these investors cannot buy bonds that are not rated by at least one or perhaps two rating agencies. Some may worry that this gives these agencies too much power, but there is a strong incentive for these ratings to be objective. If a rating agency is either too conservative or too “loose” with its ratings, it would lose credibility among investors and would become irrelevant.
Are rating agencies regulated? What is an NRSRO?
As described above, investors rely on credit ratings in many ways. Ratings are also referred to in legislation, in rules issued by regulators, and in private financial contracts. This could be a problem if there were no standards for what it means to be a rating agency. This concern gave rise to the concept of a nationally recognized statistical rating organization, or “NRSRO”.
As the name suggests, being designated as an NRSRO means the U.S. Securities and Exchange Commission (SEC) acknowledges that a rating agency is nationally recognized. The laws, rules, and contracts that refer to the use of credit ratings almost always specify that the ratings must be assigned by NRSROs.
Note that the SEC does not actually define what an NRSRO is, but a credit rating agency must apply to receive the designation and provide certain information to the SEC and the public about its business. Currently, the SEC lists ten rating agencies as NRSROs (three of them focus on bond issuers in Canada, Mexico, or Japan, and one specializes in the insurance industry). Here, we discuss the three NRSROs that provide the most widely-used credit ratings in the U.S.
History – In 1862, Henry Varnum Poor published a guide to help investors monitor the performance of U.S. railroads. In 1906, the Standard Statistics Bureau was formed to give investors information about non-railroad industrial companies. In 1916, Poor’s Publishing issued its first credit ratings and Standard Statistics did so in 1922. The two companies merged in 1941, to offer credit ratings, business information, and stock market indices to investors around the world. In 1966, Standard & Poor’s joined McGraw-Hill, a publishing giant and owner of the Dow Jones group of indices. Today, the company is branded as S&P Global.
# of issuers rated – S&P provides credit ratings on over 4,600 corporate issuers, and roughly 200,000 municipal securities. Globally, it has over 1 million ratings outstanding
Interesting factoid – In addition to credit ratings, S&P Global manages the S&P 500 and many other stock indexes. It also created the CUSIP system that assigns a unique identifier to each security traded in the U.S.
History – In 1900, John Moody published Moody’s Manual of Industrial and Miscellaneous Securities. In 1909, he established Moody’s Corporation to produce manuals of statistics about stocks and bonds, as well as bond ratings. In 1962, the company (which had become Moody’s Investors Service) was bought by Dun & Bradstreet, a credit reporting services firm. Few synergies developed between the two and Moody’s was spun off in 2000. The firm has made numerous acquisitions over the past 20 years to expand its data and analytics services globally, but is still probably best known for its bond ratings.
# of issuers rated – Moody’s Investor Services rates over 33,900 entities and transactions
Interesting factoid – Moody’s bond ratings do not predict whether a bond issuer will default over a specific investment horizon. Rather, they provide signals about relative default risk over multiple investment horizons.
History – John Knowles Fitch and two other investors launched the Fitch Publishing Company in 1913. The company’s most successful product, the Fitch Bond Book, offered a collection of bond data directly to investors. Also known as “Fitch Investors Service”, the company grew through mergers with and acquisitions of other rating agencies such as IBCA (International Bank Credit Analysis, Ltd.), Duff & Phelps, and Canada’s Thomson BankWatch, expanding its coverage across sectors, geographic regions, and security types. In addition to ratings, Fitch now offers analytical tools and risk services to corporations and asset managers.
# of issuers rated – Fitch rates over 21,000 entities including corporations, banks, sovereigns, and municipalities
Interesting factoid – Fitch, now 100% owned by the Hearst Corporation, continues to expand into adjacent businesses and in 2022 acquired GeoQuant, an AI-driven data and technology company that measures and predicts geopolitical and country risks at high frequency.
Ranging from highest quality (lowest likelihood of default) to lowest (usually in default), the three most widely used rating agencies’ rating hierarchies are as follows:
Rating agency growth areas
To grow their businesses and stay relevant, rating agencies seek to offer new types of ratings that reflect developments affecting corporations, governments, and other entities that borrow in the capital markets. Here are a few of the latest trends in rating agencies’ businesses:
ESG – Investors now recognize that Environmental, Social, and Governance (ESG) factors can affect a borrower’s long-term sustainability in ways that do not show up in traditional financial statements. Various rating agencies have developed ESG scores, ratings and other metrics to help investors analyze ESG-related risks and opportunities.
Cybersecurity – The growing financial threat presented by cybersecurity risks (including data hacks, ransomware, and interference with critical infrastructure, among others). A number of companies now offer cybersecurity ratings that claim to quantifiable measure an organization’s cybersecurity performance. Some view this as a part of the “Governance” component of ESG.
Indices – An ongoing area of development for rating agencies is to use their ratings to define indices that represent various segments of the bond market. Indices can be used as the basis for financial products such as ETFs, that passively deliver exposure to a specific segment of a market, and as performance benchmarks that are used to judge the performance of active investment managers that seek to outperform a given market segment.