Bond Rating Guidelines
Credit rating agencies are privately organized companies set up to apply ratings to individual debt securities and entire entities that wish to issue bonds within capital markets. The issuers of these debt securities include publicly traded corporations and distinct branches of government. Bond ratings effectively influence capital flows by supplying and confirming information to investors. Of course, the role of these intermediaries is never without controversy.
As of 2009, the U.S. Securities and Exchange Commission (SEC) has identified ten Nationally Recognized Statistical Rating Organizations (NRSRO) that are registered by the Commission to rate financial institutions, corporations, asset-backed securities and government debt for sale in the United States. Fitch, Moody’s and Standard & Poor’s are the most recognized CRAs in America and account for the majority of the market share within the bond rating industry.
Individual bonds and entire entities are categorized according to their ability to repay money back to lenders, or bondholders. Credit rating agencies perform fundamental analyses of private institutions that measure cash flow, profitability, corporate structure and management decision making before making conclusions. Municipal governments will be judged upon overall economics, political stability, taxation and budget controls.
Conservatively managed entities with low debt levels and high cash reserves are deemed to be friendly to bondholders and receive the highest ratings. Institutions that must take on large levels of debt to fuel growth and finance operating costs are downgraded.
Credit rating agencies present lettering to apply investment grade, non-investment grade and default status for bonds. Moody’s, S&P and Fitch use Aaa and AAA ratings to describe prime debt that is a conservative investment with the least probability for default.
Non-investment grade bonds are actually speculative positions that carry high potential for capital gains and interest payments, alongside elevated risks for losses and defaults. Non-investment grade would be associated with high-yield, or “junk” bonds.
Investors rely upon bond ratings to confirm their own analyses and align debt security purchases with financial goals. Conservative investors will look towards top-rated bonds that are most likely to hold value by making interest payments and repay principal on time. In fact, large institutional investors such as insurers and sovereign funds often feature investment restrictions that only allow them to purchase prime-rated bonds.
Speculative investors appreciate the potential for higher interest payments and capital appreciation that is a function of lower-grade bonds. Investors demand higher interest rates as compensation for taking on more risk. Conversely, debt issuers review bond ratings and make plans to achieve higher scores that effectively lower interest payments and financing costs.
The high barriers of entry that require large amounts of capital, connections and business reputation, eliminates competition from the bond-rating business. Investors believe this lack of competition leads to groupthink, where the major credit rating agencies wrongly assign similar ratings to securities with little threat of recourse from more intelligent operators.
CRAs are also paid by the debt issuer to rate bonds and provide advice. This conflict of interest may pressure these firms to assign higher ratings than reality would suggest, for the sake of keeping business. Credit rating agencies are criticized whenever investment-grade bonds default, as were the happenings associated with the 2007-2009 recession.