Rating Agency

Evaluates financial entities' creditworthiness, assigning ratings to debt instruments

Author: Matthew Retzloff
Matthew Retzloff
Matthew Retzloff
Investment Banking | Corporate Development

Matthew started his finance career working as an investment banking analyst for Falcon Capital Partners, a healthcare IT boutique, before moving on to work for Raymond James Financial, Inc in their specialty finance coverage group in Atlanta. Matthew then started in a role in corporate development at Babcock & Wilcox before moving to a corporate development associate role with Caesars Entertainment Corporation where he currently is. Matthew provides support to Caesars' M&A processes including evaluating inbound teasers/CIMs to identify possible acquisition targets, due diligence, constructing financial models, corporate valuation, and interacting with potential acquisition targets.

Matthew has a Bachelor of Science in Accounting and Business Administration and a Bachelor of Arts in German from University of North Carolina.

Reviewed By: Hassan Saab
Hassan Saab
Hassan Saab
Investment Banking | Corporate Finance

Prior to becoming a Founder for Curiocity, Hassan worked for Houlihan Lokey as an Investment Banking Analyst focusing on sellside and buyside M&A, restructurings, financings and strategic advisory engagements across industry groups.

Hassan holds a BS from the University of Pennsylvania in Economics.

Last Updated:October 7, 2023

What Is A Rating Agency?

A rating agency evaluates financial entities' creditworthiness, assigning ratings to debt instruments. These assessments guide investors, shaping decisions in capital markets indicating payment reliability and default risks.

A credit rating from one or more credit rating organizations is attached to most debt instruments issued in the public international securities markets (CRAs).

A rating agency can check the creditworthiness of issuers of debt obligations, debt instruments, and, in some situations, underlying debt servicers, but not individual customers.

The goal of credit rating agencies (CRAs) is to offer an objective and analytical assessment of the risk of payment defaults by examining a variety of criteria that assist investors in determining whether or not to invest in certain securities.

Investors in capital markets are risk-averse, and some are prohibited from investing in low-grade assets by their investment policies or guidelines. Generally, the bigger the investment risk, the larger the investor's desired return (interest/coupon).

Credit ratings are also used by financial intermediaries, such as investment banks, to ease the structuring and issuing of securities in the capital markets. They utilize credit ratings to estimate the possible price of individual debt issues and benchmark other debt issues' relative credit risk.

The credit rating industry is highly consolidated, with major credit rating companies, such as Moody's Investors Service, Standard & Poor's (S&P), and Fitch Ratings, dominating the market.

Moody's Investors Service and Standard & Poor's (S&P) control 80% of the worldwide market, with Fitch Ratings controlling 15%.

    Key Takeaways

    • Rating agencies evaluate creditworthiness, guiding investors in capital markets. They assess debt instruments, guiding investment decisions by indicating payment reliability and default risks.
    • Standard & Poor's (S&P), Moody's Investors Service, and Fitch Ratings are significant ratings agencies. They assess various entities, impacting interest rates on bonds, loans, and global financial stability. Each agency has specific expertise areas.
    • Rating agencies use diverse ratings (like AAA, A, B) to signify risk levels. These ratings reflect the likelihood of timely debt repayment, influencing investor confidence. Higher ratings indicate lower risk and vice versa.
    • Rating agencies assess industry and business risks, financial strength, and adaptability. Factors like industry prospects, demand, and financial structure impact ratings. Comprehensive analyses include cash flows, profitability, and economic adaptability.

    The Big 3 Credit Rating Agencies

    The "Big Three" credit rating agencies, such as Standard & Poor's (S&P), Moody's Investors Service, and Fitch Ratings are significant players in the global financial system.

    The primary role of these agencies involves evaluating the creditworthiness of various entities, such as corporations and governments, by assigning credit ratings that signify the associated risk level.

    To understand better, let's take a brief look at each of the firms below:

    • Standard & Poor's, under S&P Global, focuses on rating corporate and government entities
    • Moody's Investors Service, a subsidiary of Moody's Corporation, is well-known for its comprehensive credit analysis across diverse sectors
    • Fitch Ratings, part of Fitch Group, specializes in rating financial institutions and sovereign entities, providing valuable insights into credit risk

    These agencies significantly impact investor decisions, influencing interest rates on bonds and loans and shaping the overall stability of international financial markets. We will take a look at all three credit rating agencies individually below.

    Moody's Corporation 

    Moody's Corporation, a credit rating agency, assigns credit ratings that assess a debtor's capacity to repay the debt through timely payments and evaluate the risk of default. 

    A rating agency can evaluate the creditworthiness of debt obligations, debt instruments, and, in some situations, underlying debt servicers, but not individual customers.

    In contrast to long-term ratings, Moody's short-term ratings are based on an issuer's ability to repay all short-term commitments rather than on specific short-term borrowing programs. 

    A short-term rating is worldwide in scope once it has been given to an issuer; it applies to all of the issuer's senior, unsecured liabilities having an initial maturity of less than one year, regardless of the currency or market in which they were issued. 

    If another business supports an issuer's rating via a letter of credit or guarantee, specific exceptions to the worldwide scope of these ratings may apply.

    It has two different ratings:

    1. Short-term Rating Definition

    • P-1: Prime-1-rated issuers (or supporting institutions) have a superior capacity to fulfill short-term loan commitments.
    • P-2: Prime-2-rated issuers (or supporting institutions) have a high capacity to fulfill short-term loan commitments.
    • P-3: Prime-3 issuers (or supporting institutions) have a reasonable capacity to repay short-term debt.
    • N-P: Not Prime issuers (or supporting institutions) do not fit into Prime rating categories.

    2. Long-term Rating Definition

    Long-term obligation ratings from Moody's are assessments of the relative credit risk of fixed-income securities with maturities longer than one year.

    They deal with the possibility of a financial commitment not being met as agreed. Therefore, the possibility of default, as well as any financial loss experienced in the case of default, is reflected in these ratings.

    Take a look below at the table to understand what different ratings mean:

    Ratings Meaning
    Aaa Obligations rated Aaa are judged to be of the highest quality, with minimal risk.
    Aa Obligations rated Aa are judged to be of high quality and are subject to very low credit risk.
    A Obligations rated A are considered upper-medium-grade and are subject to low credit risk.
    Baa Obligations rated Baa are subject to moderate credit risk. They are considered medium-grade and, as such, may possess speculative characteristics.
    Ba Obligations rated Ba are judged to have speculative elements and are subject to substantial credit risk.
    B Obligations rated B are considered speculative and are subject to high credit risk.
    Caa Obligations rated Caa are judged to be of poor standing and are subject to very high credit risk.
    Ca Obligations rated Ca are highly speculative and are likely in, or very near, default, with some prospect of recovery in principal and interest.
    C Obligations rated C are the lowest-rated class of bonds and are typically in default, with little prospect for recovery of principal and interest.

    S&P Global ratings

    S&P Global Ratings (formerly Standard & Poor's and abbreviated as S&P) is a section of S&P Global that produces financial research and analysis on stocks, bonds, and commodities. 

    The big three credit-rating organizations include Moody's Investors Service and Fitch Ratings. The company is headquartered at 55 Water Street in Lower Manhattan, New York City.

    Long-term Rating Definition 

    The scale ranges from AAA to D, with (+) and (-) ratings available at each level between AA and CCC (for example, BBB+, BBB, and BBB-). 

    S&P may also provide advice (known as a credit watch) on whether an issuer's credit rating is likely to be upgraded (positive), downgraded (negative), or remain unchanged (neutral).

    • Investment Grade: AAA, AA, A, BBB (from the highest grade to a good quality that is susceptible to changing economic situations).
    • Non-Investment Grade (Junk): BB, B, CCC, CC, C (speculative; ranging from the most basic to the most advanced levels of speculation); D (in payment default).

    Short-term Rating Definition 

    From A-1 to D, the scale is used. A plus sign (+) next to an A-1 rating indicates the issuer's commitment to meet its obligations is particularly strong.

    • A-1, A-2, A-3 (from the highest grade to a good quality susceptible to changing economic situations).
    • B, B-1, B-2, B-3 (speculative; ranging from the most speculative to the most speculative). 
    • C (the issuer is vulnerable to nonpayment and is dependent on favorable corporate, financial, and economic conditions).
    • D is for (in payment default or bankruptcy petition filed).

    Fitch Ratings

    Fitch Ratings is a credit rating company based in New York and London. Investors use this company's ratings to identify assets unlikely to default and provide a favorable return. 

    It is the third-largest NRSRO rating agency, with a smaller market share than S&P and Moody's. At the same time, it has grown through acquisitions and frequently serves as a "tie-breaker" when the other two agencies have ratings that are similar in scale but not equal.

    It also has two different ratings:

    Long-term Rating Definition 

    1. Investment class
      • AAA: A corporation of exceptional quality (established with stable cash flows) 
      • AA: A high-quality company with a risk somewhat higher than AAA
      • A: A company with a low risk of default is more susceptible to economic or business circumstances
      • BBB: The company's default expectations are low. On the other hand, economic or business variables can have a negative impact
    2. Non-investment class
      • BB: Vulnerability to default risk is increased, as is susceptibility to unfavorable market or economic developments
      • B: The financial situation is deteriorating, and the market is highly speculative
      • CCC: Substantial credit risk, low margin of safety, and high possibility of default
      • CC: The likelihood of default is extremely high
      • C: Start with the default or a process similar to the default
      • RD: The issuer's payment default has been documented. D: The company has defaulted

    Short-term Rating Definition 

    Fitch's short-term ratings imply the likelihood of default during the next 12 months. 

    • F1: highest quality rating, showing the obligor's excellent ability to pay its financial obligations
    • F2: good quality grade with the obligor's ability to satisfy its financial obligations
    • F3: a fair quality grade, indicating that the obligor has the financial capacity to satisfy its obligations but that a near-term unfavorable situation may jeopardize the obligor's obligations
    • B: speculative, with the obligor having limited capacity to satisfy its obligations and being vulnerable to short-term bad financial and economic situations
    • C: The risk of default is significant, and the obligor's financial commitment is contingent on continued, favorable business and economic conditions
    • D: The obligor has defaulted because they have failed to meet their financial obligations

    Rating Agency Advantages

    Some of the advantages are:

    1. Freedom of Investment Decisions

    It is quite difficult for ordinary individuals to make investing decisions. Instead, they seek guidance from financial advisors, investment consultants, and portfolio managers before making financial decisions.

    Credit rating services simplify the work by assigning rating symbols to a specific investment. Therefore, credit rating is one of the most important aspects to consider while doing the entire valuation

    2. Lower the Cost of Public Issue

    When acquiring cash through a public offering, a company with highly rated instruments must put forth the least amount of work. In addition, a strong credit rating boosts the company's visibility. 

    Companies with highly rated instruments have superior goodwill and corporate image in the eyes of consumers, shareholders, investors, and creditors. 

    This is particularly relevant for companies adhering to ESG (Environmental, Social, and Governance) investing principles. 

    3. Lowers Cost of Borrowing

    When raising cash from the market, a corporation with highly rated debt instruments can do so more easily and at a lower cost due to investor confidence in the high credit rating. A high rating indicates low risk. 

    The corporation will be able to give a low interest rate due to the instrument's high rating. Because there is little danger involved, investors will accept a low interest rate. 

    A high credit rating allows the organization to borrow from various sources. For example, it can readily borrow money from financial institutions, banks, investment firms, and the general public.

    Rating Agency Disadvantages

    A few of the disadvantages are:

    1. Possibility of Bias

    The credit rating agency may not receive all material or important information from the rated company. Therefore, any action made without such critical information may result in investors losing. 

    However, since 2008, a lot of changes have been made to the system, and the norms have gotten stricter. This can address such a disadvantage and reduce the risk of false crediting.

    2. Problems for New Company

    Rating organizations use the information provided by the company to assign ratings. On the other hand, a new company may not be able to present enough evidence to demonstrate its financial stability.

    As a result, it may receive a lower credit rating. A poor credit rating might make obtaining loans from the market difficult. The impact of credit ratings on investment analysis for new companies is not clearly conveyed, and the sentence needs clarification. 

    3. Ratings are not a Certificate of Soundness

    The rating agencies' grades are their judgment of the company's ability to satisfy its interest obligations. 

    Rating symbols do not indicate product quality, management, or personnel, among other things. To put it another way, a rating does not imply that a corporation is completely sound.

    A variety of political, economic, social, and environmental factors have a direct impact on the company's operations. Therefore, any changes made after the rating may defeat the rating's objective.

    Rating Methodology

    Some of the methodologies of the rating agencies are:

    1. Business Risk Analysis

    A business risk analysis aims to examine the industry risk, the company's market position, operational efficiency, and legal situation. 

    This involves an examination of industry risk, the company's market position, operational efficiency, and legal situation.

    2. Industry Risk

    Rating agencies assess industry risk by considering a variety of variables, such as the strength of the industry's prospects, the type and foundation of competition, demand and supply, industry structure, business cycle pattern, and so on. 

    Price, product quality, distribution capacity, and other factors pit industries against one another. Industries with predictable demand growth and capital expenditure flexibility are often considered more stable, potentially leading to a higher credit rating due to reduced business risks.

    3. Financial Analysis

    Through ratio analysis, cash flow analysis, and an assessment of the company's capital structure, financial analysis aims to determine the issuing company's financial strength. 

    This includes an examination of four critical factors: a. Accounting quality, b. Profitability/earnings potential c. Analysis of Cash Flows d. Economic adaptability 

    Financial analysts use quantitative methods such as ratio analysis to determine the issuer company's financial strength. In addition, a company's history and current performance are assessed to forecast its future performance. The following are the areas that were considered.

    Existing The debt/equity ratio, alternative sources of financing used to generate cash, ability to raise funds, asset deployment potential, and other aspects of a company's capital structure are all examined.

    Did You Know?

    Credit rating agencies (CRAs), which grade debt instruments/securities based on the debtor's ability to repay lenders, played a key part in the subprime mortgage crisis in the United States in 2007–2008, which led to the Great Recession of 2008–2009. 

    Without ratings from the "Big Three" rating agencies—Investors Moody's Service, Standard & Poor's, and Fitch Ratings—the new, complicated "structured finance" products used to finance subprime mortgages could not have been offered. 

    For example, many money markets and pension funds were legally required to hold only the safest securities—those rated "triple-A" by rating organizations. So, these agencies were one of the main reasons that led to the  Recession in 2008.

    Researched and authored by Charbel Yammine | LinkedIn

    Reviewed and edited by Aditya Salunke I LinkedIn

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