When investing in bonds, the most important question to consider is the credit quality of the issuer relative to the pricing of the security.  While professional asset managers and insurance companies that hold large portfolios of bonds often have teams of credit analysts to assess a bond issuer’s financial condition, many investors rely primarily on the credit ratings assigned by independent firms, known as credit rating agencies.

 What is a Credit Rating Agency?

Rating agencies assign credit ratings based on their view of the likelihood that a borrower (a corporation, bank, government entity, or some other entity) might fail to make timely payments of interest and principal on a security.

Why are rating agencies useful?

Credit rating agencies provide a valuable service to both investors and issuers. Without their ratings:

• Every investor would have to do his/her own credit risk analysis before buying any bond. It would take time and resources to gain a sufficient understanding of the borrower’s business outlook, industry, and financial condition. This would limit the number of bonds any investor would be able to consider.
• Corporations, governments, and others that want to borrow in the capital markets would have to spend more time educating investors about their business, industry and financial condition. That would likely limit the number of investors a given borrower would attract, reducing the demand for its bonds. Issuers would probably have to offer a higher coupon rate on their bonds to get investors’ attention, thus increasing their cost of borrowing.

Many institutional investors (pension funds, insurance companies, and others) have policies that specify the credit quality of bonds they are allowed to buy, defined by the ratings the credit rating agencies assign. Often, these investors cannot buy bonds that are not rated by at least one or perhaps two rating agencies.

Are rating agencies regulated? What is an NRSRO?

As described above, investors rely on credit ratings in many ways. Ratings are also referred to in legislation, in rules issued by regulators, and in private financial contracts. This could be a problem if there were no standards for what it means to be a rating agency. This concern gave rise to the concept of a nationally recognized statistical rating organization, or “NRSRO”.

As the name suggests, being designated as an NRSRO means the U.S. Securities and Exchange Commission (SEC) acknowledges that a rating agency is nationally recognized.[1] The laws, rules, and contracts that refer to the use of credit ratings almost always specify that the ratings must be assigned by NRSROs.

Note that the SEC does not actually define what an NRSRO is, but a credit rating agency must apply to receive the designation and provide certain information to the SEC and the public about its business. Currently, the SEC lists ten rating agencies as NRSROs (three of them focus on bond issuers in Canada, Mexico, or Japan, and one specializes in the insurance industry). Here, we discuss the three NRSROs that provide the most widely-used credit ratings in the U.S.

S&P Global

History – In 1862, Henry Varnum Poor published a guide to help investors monitor the performance of U.S. railroads. In 1906, the Standard Statistics Bureau was formed to give investors information about non-railroad industrial companies. In 1916, Poor’s Publishing issued its first credit ratings and Standard Statistics did so in 1922. The two companies merged in 1941, to offer credit ratings, business information, and stock market indices to investors around the world. In 1966, Standard & Poor’s joined McGraw-Hill, a publishing giant and owner of the Dow Jones group of indices. Today, the company is branded as S&P Global.

# of issuers rated – S&P provides credit ratings on over 4,600 corporate issuers, and roughly 200,000 municipal securities. Globally, it has over 1 million ratings outstanding

Moody’s

History ­– In 1900, John Moody published Moody’s Manual of Industrial and Miscellaneous Securities. In 1909, he established Moody’s Corporation to produce manuals of statistics about stocks and bonds, as well as bond ratings. In 1962, the company (which had become Moody’s Investors Service) was bought by Dun & Bradstreet, a credit reporting services firm. Few synergies developed between the two and Moody’s was spun off in 2000. The firm has made numerous acquisitions over the past 20 years to expand its data and analytics services globally, but is still probably best known for its bond ratings.

# of issuers rated – Moody’s Investor Services rates over 33,900 entities and transactions

Fitch

History ­– John Knowles Fitch and two other investors launched the Fitch Publishing Company in 1913. The company’s most successful product, the Fitch Bond Book, offered a collection of bond data directly to investors. Also known as “Fitch Investors Service”, the company grew through mergers with and acquisitions of other rating agencies such as IBCA (International Bank Credit Analysis, Ltd.), Duff & Phelps,  and Canada’s Thomson BankWatch, expanding its coverage across sectors, geographic regions, and security types. In addition to ratings, Fitch now offers analytical tools and risk services to corporations and asset managers.

# of issuers rated – Fitch rates over 21,000 entities including corporations, banks, sovereigns, and municipalities

Fitch, now owned by the Hearst Corporation, continues to expand into adjacent businesses and in 2022 acquired GeoQuant, an AI-driven data and technology company that measures and predicts geopolitical and country risks at high frequency.

Ratings Methodology

 Ranging from highest quality (lowest likelihood of default) to lowest (usually in default), the three most widely used rating agencies’ rating hierarchies are as follows:

Rating agency growth areas

To grow their businesses and ensure continued relevance in new and emerging sectors of the capital markets, rating agencies seek to offer new types of ratings that reflect developments affecting corporations, governments, and other entities that borrow in the capital markets. Here are a few of the latest trends in rating agencies’ businesses:

ESG – Investors now recognize that Environmental, Social, and Governance (ESG) factors can affect a borrower’s long-term sustainability in ways that do not show up in traditional financial statements. Various rating agencies have developed ESG scores, ratings and other metrics to help investors analyze ESG-related risks and opportunities.

Cybersecurity – The growing financial threat presented by cybersecurity risks (including data hacks, ransomware, and interference with critical infrastructure, among others).  A number of companies now offer cybersecurity ratings that claim to quantifiable measure an organization’s cybersecurity performance. Some view this as a part of the “Governance” component of ESG.

[1] https://www.sec.gov/rules/proposed/33-8570.pdf