Similar to the credit ratings of individuals, credit ratings are assigned to each issuer of debt obligations. This rating affects the interest rate of the loan and also help investors categorize the many different types of debt that are issued today.
Credit Rating Agencies (CRA) are companies that perform and assign these credit ratings. For years, these companies provided a great service for both corporations and investors but the financial crisis of 2008 has put into question the integrity, objectivity and reliability of these ratings.
The Role of Credit Rating Agencies
The CRAs continually rate corporations as an indicator of the safety of its debt securities (ie, the company’s ability to pay back the loan). Every agency have its own rating and naming conventions but they are mostly alphabetic that range from AAA (the highest grade) to BBB or lower.
A corporation or debt with a rating of AAA is considered very high (with a very small chance of default) while a debt with BBB (some agencies give C and D ratings) is considered junk (ie, a high chance of default). Therefore, debt with a low rating naturally has a higher yield to compensate the investor for the added risk.
As you can see, it is very desirable for a corporation to have a high rating because such firms will have an added advantage of issuing debt at a lower interest rates.
Compensation Structure of CRAs
Currently, issuers actually pay the credit rating agencies to rate them. Therefore, some critize that credit rating agencies are reluctant to give them a lower rating because of being afraid that the corporations will go to its competition. While the CRAs defend that this conflict of interest is largely unproven, it’s a real concern of the industry.
For example, during the housing bubble of 2000 – 2007, many credit rating agencies gave collateral debt obligations based on mortgages credit ratings of AAA even though the mortgages themselves were rated much lower. The argument was that because the lower rated loans were divided up and packaged effectively, the chances of default went way down. However, this all proved to be completely wrong as the housing bubble caused many of these debt securities to default and sent the globe into the financial crisis that’s happening today.
How Ratings from CRAs are Used
Nevertheless, credit agencies still provide a useful function in the world of finance today. They are used by:
- Investors – The ratings provide an additional point of independent research on all investable debt obligations in the market.
- Investment Bank and Dealers – Investment banks are always trying to maximize returns and minimize risks. The credit ratings help them gave the overall risk on their portfolios to do so.
- Debt issuers – When an entity issues a bond, they heavily rely on the credit ratings to price the bond and also its interest rates.
- Regulators – Government agencies, such as the Security Exchange Commission, allow financial institutions with a higher credit rating more leeway in its capital reserve ratio because these institutions are deemed safer from the scenario of “run on the bank”.
What Credit Ratings Mean for Us
Credit rating agencies provide an independent gauge of credit risk which in turn increases the ease of investing in debt obligations. While no agency is perfect, investors like us can use the credit ratings to determine whether a particular bond is safe and whether bond fund managers are doing what they are supposed to do. Credit ratings are by no means the end all and be all, but if we pretty can get free access to another piece of information to help our investing decisions, why not?