Credit rating agency

A credit rating agency provides independent assessments, in the form of credit ratings, of the probability of default of companies, governments and the providers of of a wide range of financial instruments. Credit ratings have major impact on the availability and cost of credit for borrowers.

Introduction: credit ratings

The term "credit" is used in this context in its sense of trustworthiness, and refers to the extent to which its subject can be trusted to be willing and able to comply with the terms of a financial contract. Assessments of individual creditworthiness (usually stated as "credit scores") are not undertaken by organisations known as credit rating agencies, and are not further referred to in this article. Credit rating agencies assess the creditworthiness of the issuers of debt instruments, including bonds issued by corporations and governments and mortgages and their derivatives, and they express their findings as alphabetically-coded "rating" categories such as AAA, AA, and BB. Credit ratings have been presented by the issuing agencies as statements of opinion, implying the absence of any legally-enforceable commitment to their reliability.

Credit rating agencies

The major credit rating agencies are located in the United States and are regulated by the United States Securities and Exchange Commission having satisfied the conditions required by that commission for their designation as "Nationally Recognized Statistical Rating Organizations" (NRSROs). They undertake "solicited ratings" for a fee at the request of the issuers of debt instruments (and also undertake "unsolicited ratings" on their own initiative and at their own expense). According to expert testimony to a Senate Committee they "do not make any significant effort to verify the facts on which their models rely", but accept the representations and data provided them by the issuing organisations .

The effects of credit ratings

Bond ratings also affect the bonds yield or the amount of return that an investor can expect on the bond. A bond which is highly rated typically has a lower yield because the issuer does not have to offer a high coupon rate in order to attract investors. This is because the high bond rating tells the investor that the company is less likely to default than most other companies. A bond which is rate lower typically has a higher yield because investors demand extra incentive to compensate for the higher risk which is involved. This extra incentive comes in the form of default risk premiums. Default risk premiums are an additional amount that borrowers must pay in order for investors to assume the higher risk. Since 1970, an average of 3.45% of speculative-grade issuers have defaulted per year, compared with just 0.05% of investment-grade issuers. Since 1983, average one year default rates rose from 0.0% for Aaa to 12.2% for B3.

Bond ratings are important because companies do default and when they do investors can lose a lot of money. There have been instances where companies have defaulted on hundreds of millions worth of bonds. AmeriServe Food Distribution Inc. defaulted on $200 million in junk bonds leaving investors with a loss of $160 million. Bond ratings are essential to the investor because they are an indicator of the default risk involved in purchasing certain bonds. With the ratings investors can make informed decisions on whether or not to purchase certain bonds.