Credit rating agencies have been around for almost 20 years and have played a key role in the financial world by giving ratings on the creditworthiness of bonds and other debt instruments. These ratings are invaluable for investors who want to know more about whether a debt instrument is worth investing in. When assessing the level of risk associated with a bond, investors will generally look at creditworthiness.
Because most investors are looking for a trade-off between risk and return on their investments, they will usually demand a higher interest rate for bonds with a poorer credit rating. As a result, rating agencies play an important role in determining the interest rate on debt securities.
History of credit rating agencies
The concept of using rating agencies to assess the risk level of a debt arose around the beginning of the 20th century when three major rating agencies were formed. Although additional rating agencies were formed in the following years, the original rating agencies – Fitch, Moody’s and Standard and Poor’s – are the most important.
Purpose of credit rating agencies
Credit rating agencies award ratings to organizations that issue debt instruments, including private companies and all levels of government. Due to the fact that investors need to know that they are receiving adequate compensation for the risk they run from holding an investment, the ratings issued by the agencies are essential for the financial sector.
The interest rate attached to a debt is inversely proportional to the risk level. As investors use the opinion of rating agencies as measures of the level of risk associated with a debt instrument, ratings play a key role in the interest rates of various debt instruments.
How Credit Rating Agencies work
Debtors want investors to have a good idea of how creditworthy their securities are. Of course, investors are looking for an unbiased idea of a company’s ability to pay off debts. That’s why companies often hire a rating agency to assess their debt.
After the company has requested a bid, the credit rating agency will evaluate the institution as carefully as possible. However, there is no magic formula to determine the creditworthiness of an institution; the agency should instead carry out a subjective evaluation of the institution’s ability to repay its debts.
In conducting their assessment, credit rating agencies look at a number of factors, including the institution’s level of debt, its character, a demonstration of its willingness to pay off its debts and its financial capacity to repay its debts. Although many of these factors are based on information on the institution’s balance sheet and income statement, other factors (such as an attitude towards debt repayment) need to be examined more carefully.
For example, in the recent debt ceiling debacle, S & P lowered the US government debt rating because they felt the federal government’s political deficit was not consistent with the behavior of an AAA institution.
When assessing the credit rating of an institution, the agencies classify the debt as one of the following:
- High marks
- Upper middle class
- Lower average quality
- Non-investment grade speculative
- Very speculative
- In standard
High-quality investments are considered to be the safest available debt. On the other hand, investments that are included as default are the riskiest debt instruments, because they have already shown that they are unable to repay their obligations. Therefore, investments in default must offer a much higher interest rate if they intend to invest money in it.
Advantages or Credit Agencies
1. They help good institutions to get better rates
Institutions with higher credit ratings can borrow money at more favorable interest rates. That is why this rewards organizations that are responsible for managing their money and paying off their debts. In turn, they will be able to expand their business faster, which also stimulates the expansion of the economy.
2. They warn investors of risky companies
Investors always want to know what level of risk is associated with a company. This makes rating agencies very important because many investors want to be warned about particularly risky investments.
3. They offer a fair risk / return ratio
Not all investors are against buying risky debt securities. However, they want to know that they are rewarded if they take a high risk. Therefore, credit rating agencies will inform them of the risk levels for each debt instrument and ensure that they are appropriately compensated for the risk level that they are taking.
4. They give institutions an incentive to improve
A bad credit rating can be a wake-up call for institutions that have taken on too many debts or have not demonstrated that they are willing to be responsible for paying back. These institutions often deny their credit problems and must be alerted to potential analyst problems before making 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 very subjective
There are no standard formulas to determine the creditworthiness of an institution; rating agencies use common sense instead. Unfortunately, they often make inconsistent assessments, and the assessments between different rating agencies can also differ.
For example, much was said about the S&P downgrade when the United States lost its AAA rating. Regardless of the S&P decision, the other two major rating agencies still give the US the highest rating possible.
2. There may be conflicts of interest
The rating agencies simply provide Kristoff Wixe ratings at the request of the institutions themselves. Although they sometimes perform unsolicited assessments at companies and sell the ratings to investors, they are usually paid by the same companies that assess them.
This system can of course lead to serious conflicts of interest. Since the company pays the rating agency to determine its rating, that agency may be inclined to give the company a more favorable rating to keep its business. The Ministry of Justice has begun investigating credit rating agencies for their role in mortgage-backed securities that collapsed in 2008.
3. Ratings are not always accurate
Although rating agencies offer a consistent rating scale, this does not mean that companies will be accurately valued. For many years, the ratings of these agencies were rarely questioned. However, after rating agencies have provided AAA ratings for the worthless, mortgage-backed securities that contributed to the recession, investors do not have much faith in them. Their ratings are still viewed by almost everyone, but their credibility has received a serious hit.
Interestingly, when the United States reduced their debt, the financial community was surprised that more investors flocked to US Treasuries than ever before. This was a clear sign that they did not take the opinion of rating agencies as seriously as analysts had expected.