Credit Rating Agencies: Definition, factors and examples

Credit rating agencies provide investors with information about the issuer’s ability to meet their obligations when they issue debt instruments. To do this, they evaluate their creditworthiness.  Keep reading to learn more about what they do, what factors they look at and how they affect the economy. 

A credit rating agency (CRA) evaluates the creditworthiness of entities such as governments, corporations, and financial instruments like bonds. They provide ratings based on the likelihood of default (the failure to make principal repayments on a debt).  

Rating agencies play a key role in financial markets by providing independent evaluations of the risk associated with investing in specific securities. They assign ratings (such as AAA or BBB) to help investors assess risk when buying bonds or other debt instruments.  

Examples of major credit rating agencies include Standard & Poor’s (S&P), Moody’s, and Fitch Ratings. 

How Do Credit Rating Agencies Work? 

CRAs analyze financial data, economic conditions, and qualitative factors to provide an assessment of the ability of a borrower to meet its financial obligations. They review factors such as revenue streams, debt levels, interest coverage, and market position when determining ratings. 

Ratings are categorized from investment grade (e.g., AAA, AA) to speculative or "junk" grade (e.g., BB, CCC). Ratings impact the yield investors demand and influence the accessibility of funding for corporations and governments. 

The Big 3 Credit Rating Agencies

There are big three rating agencies which control about 95 % of the credit rating industry:

Moody’s Investors Service

This rating agency is based in the United States. It is a leading provider of credit ratings, research, and risk analysis. It rates debt securities in various bond market segments, including government, municipal, and corporate bonds. Moody’s is famous for its rigorous and transparent methodologies, which help investors assess the credit risk of different securities.

S&P Global Ratings

Originally known as Standard & Poor’s, this rating agency is renowned for its comprehensive financial research and analysis. It became a part of S&P Global in 2016. S&P is famous for its credit ratings, and it is also known for financial indices through its affiliated index businesses.

Fitch Group

Fitch Ratings was founded in 1914 and its known for its detailed credit ratings and financial research. It provides ratings for financial institutions and a wide range of financial instruments such as mortgage backed securities. Fitch is unique in its dual-headquartered structure, with offices in both New York and London. It is often seen as a “tie-breaker” when the other two agencies have similar but not identical ratings.

An example of ratings assigned to a corporation by one of the big three rating agencies is Moody's Investors Service rating for Apple Inc. Moody's assigned Apple Inc a long-term rating of Aa1. This rating indicates that Apple has a very low credit risk and is considered a high-quality borrower. The Aa1 rating is just one notch below the highest possible rating (Aaa).

These rating agencies are well-known because their ratings are widely used by investors, financial institutions, and governments to make informed decisions about risk and investment opportunities. Their ratings can significantly impact the financial markets and the cost of borrowing for entities around the world.

What Are Credit Ratings? 

Credit ratings are symbolic grades that reflect the credit risk of an entity or a financial instrument, with higher ratings indicating lower risk.

A high rating (such as AAA, AA, and A) reflects that, in the rating agency’s opinion, an issuer is likely to repay its debts without difficulty. On the other hand, lower ratings (BB and below) suggest speculative risks of the issuer struggling to make its payments.  

A low credit rating or a high credit rating will impact a company’s ability to borrow money and the terms on which they can do so. In the case of investors, they use credit ratings to decide whether to do business with the rated entity and to determine how much interest they would receive to compensate them for the risk. 

Sovereign ratings (the assessment of the creditworthiness of a country or sovereign entity) assess the risk associated with a country’s ability to repay its debt, influencing global trade and investment. 

What Factors Do Credit Rating Agencies Look At? 

Credit rating agencies look at many different factors when carrying out credit assessments. The major factors are:  

• Payment history: agencies look at the entity’s overall history of borrowing and repayment behavior, as well as records of any previous defaults or financial distress.  
• Debt levels: the amount they currently owe and the types of debts. 
• Financial health: current cash flows, revenue, and earnings. 
• Economic environment: the industry conditions and market trends as well as other factors that might impact the economic outlook. 
• Other unique issues that will affect the entity or person being rated. 

The Role of Credit Rating Agencies in Financial Markets 

Credit rating agencies are essential to the smooth functioning of capital markets, helping investors make informed decisions. Credit ratings provide transparency and reduce information asymmetry between issuers and investors. Their assessments can affect bond prices, stock performance, and a country’s access to international capital markets. 

They are also important for both investors and for the entities they rate. A high rating can give a company or a government the capital they need at interest rates they can afford, while a low rating might mean that they will not be able to access capital.  

Can Credit Ratings Affect Economic Stability? 

Following the Great Recession of 2007 to 2009, it was argued that CRAs provided inaccurate positive ratings, leading to bad investments. The agencies were accused of attempting to raise profits and their market share in exchange for these inaccurate ratings. This helped lead to the subprime mortgage market collapse that led to the financial crisis. Since then, there has been more scrutiny and regulatory pressure on rating agencies.  

Who Regulates Credit Rating Agencies? 

CRAs are regulated to ensure their ratings are objective and fair, given their influence on global markets. 

• In the U.S., the Securities and Exchange Commission (SEC) oversees credit ratings agencies as "Nationally Recognized Statistical Rating Organizations" (NRSROs, a framework strengthened significantly by Dodd-Frank after the 2008 crisis.
• In Europe, the European Securities and Markets Authority (ESMA) regulates CRAs. 
• CRAs operating in the UK are regulated by the FCA under the retained EU law version of the CRA Regulation.  

Post-financial crisis reforms have increased the scrutiny and accountability of CRAs to avoid conflicts of interest. 

FAQs 

What's the Difference Between a Credit Rating and a Credit Score? 

Credit ratings apply to governments, corporations, and financial instruments. Credit scores apply only to individuals and are issued by consumer credit bureaus.

How Do Credit Ratings Affect Debt Instrument Valuations? 

Generally, investors prefer instruments with a lower default probability. Credit ratings allow investors to rank debtors in order of default probability and assess the risk. An improvement in a credit rating typically increases a bond’s price and lowers its yield, as investors demand less compensation for risk.

How Do Credit Ratings Impact Borrowing Costs? 

Credit ratings impact borrowing costs because they directly impact loan eligibility and interest rates. A higher credit rating will often result in better loan terms, lower interest rates and more attractive repayment options.  

On the other hand, those with non-investment grade ratings (below BBB-) may struggle to find willing lenders and might have to rely on more expensive or restrictive financing options.

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This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.