Rating agencies: how to read the results

Credit rating agencies (CRAs) are very well known and authoritative players in the financial world, feared in some respects, but also the subject of considerable criticism (especially in the wake of the 2008 financial crisis). But what are they and how do they work?

The role and activities of CRAs

In the world of finance, there is a very useful tool for navigating the galaxy of debt issuers, from companies to government agencies and sovereigns, on the basis of their creditworthiness: credit rating agencies, private companies that assign a rating to an issuer's ability to repay its financial obligations. These ratings play a very important role in the financial markets, particularly in the bond market. The rating agencies' assessments are based on an analysis of an issuer's financial strength: to make such an assessment, data and information are analysed, both on the company (or government agency or state) and on the sector and environment in which it operates: both "specific" and "systematic" risks are therefore taken into account.

The impact of rating agencies

Ratings can have a direct impact on both investors' decisions and an issuer's cost of capital: if an issuer's rating is high, that issuer is likely to have a lower average cost of raising new capital; conversely, if its rating is low, an issuer is likely to have to offer a higher average remuneration to lenders or investors in order to access finance. These ratings are, of course, subject to change over time as the issuers' financial conditions change.

The rating scales

The three major rating agencies, Standard & Poor's, Moody's and Fitch, have rating scales ranging from the highest 'AAA' rating ('Aaa' for Moody's) to 'D' ('C' for Moody's).

• The highest 'AAA' rating indicates the strongest ability to meet financial obligations.
• Issuers with a rating of 'AAA' to 'BBB-' (for S&P and Fitch, 'Aaa' to 'Baa3' for Moody's) are referred to as 'investment grade' and offer relative security to investors.
• Below 'BBB-' (for S&P and Fitch, below 'Baa3' for Moody's) you enter the 'speculative grade' range: these are investments that offer higher average returns but at the price of higher risk.
• A 'D' rating ('C' for Moody's) indicates either issuers in default or those with serious financial strength problems.

Upgrades and downgrades

As mentioned above, a rating agency's ratings can change over time. In fact, their activities are not limited to issuing a one-off rating, but to constantly monitoring the financial strength of financial issuers. The creditworthiness of a company/government/state may improve, resulting in a so-called 'upgrade', or the creditworthiness of an issuer may deteriorate, resulting in a so-called 'downgrade'.

See also

What are bonds and how do they work?

From the glossary:

• Systematic Risk
• Unsystemic Risk