It can get tricky sometimes to tell if a bond is worth buying, because risk alone is not the only factor to consider. Credit ratings, as determined by one or more of the major credit rating agencies are highly important. But what exactly are these agencies and what is their purpose? And the biggest question of all -- do they rate bonds in the same way?
What are credit rating agencies and what is their purpose?
Credit rating agencies assess the relative credit risk of specific debt securities or structured finance instruments and borrowing entities (issuers of debt), and in some cases the creditworthiness of governments and their securities. By serving as information intermediaries, credit rating agencies theoretically reduce information costs, increase the pool of potential borrowers, and promote liquid markets. These functions may increase the supply of available risk capital in the market and promote economic growth.
Who are the major players?
There are 3 major credit rating agencies that evaluate the risk and rates for debts. Here is a little information on each:
The company ranks the creditworthiness of borrowers using a standardized ratings scale which measures expected investor loss in the event of default. Moody's Investors Service rates debt securities in several market segments related to public and commercial securities in the bond market. These include government, municipal and corporate bonds; managed investments such as money market funds, fixed-income funds and hedge funds; financial institutions including banks and non-bank finance companies; and asset classes in structured finance. In Moody's Investors Service's ratings system securities are assigned a rating from Aaa to C, with Aaa being the highest quality and C the lowest quality.
Standard & Poor's (S&P)
This agency issues credit ratings for the debt of public and private companies, and other public borrowers such as governments and governmental entities. It is one of several CRAs that have been designated a nationally recognized statistical rating organization by the U.S. Securities and Exchange Commission.S&P issues both short-term and long-term credit ratings. The company rates borrowers on a scale from AAA to D. Intermediate ratings are offered at each level between AA and CCC (e.g., BBB+, BBB and BBB−). For some borrowers, the company may also offer guidance (termed a "credit watch") as to whether it is likely to be upgraded (positive), downgraded (negative) or uncertain (neutral).
Lastly, Fitch's is the smallest of the "big three" NRSROs, covering a more limited share of the market than S&P and Moody's, though it has grown with acquisitions and frequently positions itself as a "tie-breaker" when the other two agencies have ratings similar, but not equal, in scale. Fitch Ratings' long-term credit ratings are assigned on an alphabetic scale from 'AAA' to 'D', first introduced in 1924 and later adopted and licensed by S&P. (Moody's also uses a similar scale, but names the categories differently.) Like S&P, Fitch also uses intermediate +/− modifiers for each category between AA and CCC (e.g., AA+, AA, AA−, A+, A, A−, BBB+, BBB, BBB−, etc.).
How are ratings determined and is there a difference?
As denoted above, each one has their own rating system, which can be very different in some instances and may give investors mixed signals about what is considered investment grade or junk grade. Here is a short, quick guide to noting the major differences:
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