The responsibility of a ratings agency is to tell current or potential investors about the creditworthiness of an instrument. The agencies use pre-established criteria to ascertain the borrower’s financial position, or ability to pay debt. They use quantitative models to determine whether the investment is a good one, but they are not always infallible. The Big Three of credit rating are certified by the U.S. Securities and Exchange Commission as a Nationally Recognized Statistical Rating Organization (NRSRO).
Investors rely on credit rating agencies to determine the perceived risk of a particular debt instrument. Some investors are required by law to restrict their bond portfolio to investment grade rated instruments. This gives a great deal of power to the ratings agencies.
An investment grade rating means that the rating agencies have found that debt instrument to have a strong likelihood of payback. In contrast, junk bonds are non-investment grade securities that contain a noteworthy level of risk. For this reason they are also called high-yield bonds.
Probably the best known of the Big Three rating agencies, Standard and Poor’s (S&P) is a company providing financial publishing, information and media to the world’s capital markets. It is owned by the McGraw-Hill Companies. S&P also publishes stock market indices, the most well-known of which is the S&P 500.
S&P’s ratings from the best quality borrowers to the lowest are: AAA, AA, A, BBB, BB, B, CCC, CC, C, and D. Investment grade is BBB and above. S&P uses plus and minus to add intermediate designations to these ratings.
Moody’s started in 1909 as a publishing company, issuing railroad bond guides called Moody’s Manuals. It later expanded its coverage to municipal and commercial bonds, and is now called Moody's Investment Services.
Moody’s uses the following ratings: Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C. Numbers are added for intermediate designations, such as Baa1, Baa2, etc. Investment grade is considered to be Baa and above; anything below is considered speculative, or junk.
Owned by a French Holding Company, Fimalac SA, Fitch operates internationally and offers financial research as well as credit rating services. The smallest of the Big Three, Fitch uses the same ratings scale as S&P.
Conflicts of Interest
Credit ratings agencies receive fees from the issuers of the securities they rate. In the time leading up to the 2008 financial crisis, S&P, Moody's and Fitch all gave consistently high ratings to mortgage-backed securities created by the investment banks who were paying them. This overrating of risky debt instruments contributed to the financial bubble and subsequent decline. Congress has proposed new regulation of these agencies to increase competition and ensure independence in this market.