Understanding Bond Rating Agencies (2024)

Bond rating agencies help you understand the risks of investing in bonds. These private companies assess the creditworthiness of bonds and the companies or governments that issue them.

What Are Bond Rating Agencies?

Bond rating agencies work somewhat like credit bureaus in that they both research financial information to determine creditworthiness. But instead of assessing an individual’s likelihood of repaying their debts, a bond rating agency determines whether the issuers of debt securities like bonds are likely to fulfill their promises to pay interest and repay the principal you loaned them.

Bond investors rely on rating agencies to help them decide where to invest their money and whether the risk involved in buying a debt security is worth the promised interest rate. In general, higher-risk bonds need to offer higher interest rates to appear worthwhile to investors.

There are three main bond rating agencies in the United States that account for approximately 95% of all bond ratings: Fitch Ratings, Standard & Poor’s Global Ratings (S&P Global Ratings) and Moody’s Investors Service. Each agency uses a proprietary evaluation methodology, so they may offer differing ratings for the same security.

While they are private companies, as of 1975, the Securities and Exchange Commission (SEC) designated these three agencies as nationally recognized statistical rating organizations (NRSROs). The SEC has since added more NRSROs, but Fitch, S&P and Moody’s still dominate this landscape.

Fitch Ratings

Founded in 1913 by John Knowles Fitch, Fitch Ratings introduced the AAA through D rating system in the 1920s. A similar ratings system has also been adopted by S&P Global Ratings.

The ratings hierarchy assigns letter grades to debt securities and their issuers based on their likelihood of default, with AAA indicating the highest creditworthiness and lowest risk of default and D signaling an issuer that has entered into bankruptcy. Bonds rated AAA, AA, A or BBB are considered investment grade while those rated BB, B, CCC, CC, C or D are considered speculative or junk grade bonds.

Fitch is the smallest of the three bond rating agencies, with 13% of the total market share. The largest share of its ratings are for financial institutions, occupying 23.6% of that market, followed by 22% of the asset-backed securities market, 16.4% of corporate issuers, 15.7% of insurance companies and, finally, 11% of government securities.

S&P Global Ratings

S&P Global Ratings is both the largest and oldest of the three bond rating agencies. Its history goes back to the 1860 publication of “History of the Railroads and Canals of the United States,” which businessman Henry Varnum Poor wrote to offer clarity to investors interested in the railroad industry.

S&P Global Ratings uses essentially the same rating scale as Fitch, hierarchically ranking securities and issuers from AAA to D. The investment grade bonds are those with a BBB or above, and speculative or junk bonds are those with a BB or below.

S&P Global Ratings commands over 50% of the bond rating market share. It handles over 54% of ratings for government securities and 44.8% of ratings for corporate issuers. However, it has a fairly high percentage of every category, with 37.2% of ratings of financial institutions, 32.3% of insurance company ratings and 23.6% of asset-backed securities ratings.

Moody’s Investors Service

Founded in 1909 by John Moody, this agency was created in the wake of the 1907 stock market crash. Having lost his business in the crash, Moody decided to begin offering investors an analysis of security values.

Moody’s has a slightly different purpose for evaluating securities. While Fitch and S&P aim to measure the likelihood that a security might default, Moody’s aims to determine the expected amount of loss in the event there is a default. This difference in primary motivation is one of the reasons why the same securities may have differing ratings among the agencies.

Moody’s ratings hierarchy goes from the investment grade ratings of Aaa, Aa, A and Baa to the speculative grade ratings of Ba, B, Caa, Ca, and C. Moody’s regards C-rated securities to be the lowest rated, and this rating typically describes securities in default. On the Fitch and S&P scales, such securities would generally receive a D rating.

This agency handles 32% of the bond rating market share. The majority of its ratings are for government securities, occupying 33.4% of that market. It also handles 31.9% of asset-backed securities, 25.9% of corporate issuers, 23.8% of financial institutions and 12% of insurance companies.

Understanding Bond Ratings

Bond ratings are assigned to both the organizations that issue bonds and the bond issues themselves. The higher a bond’s letter rating rating, the lower the interest rate coupon needs to be because the issuer has a lower risk of default. Conversely, the lower a bond’s rating, the more interest an issuer needs to pay to incentivize investors to buy.

Benefits of Bond Rating Agencies

Just like having a good credit score allows individuals to access more favorable loan terms, having a good rating from the bond ratings agencies helps organizations borrow money more cheaply. Ratings can also provide an incentive to organizations to stay current with their debts and not take on more debt than they can comfortably afford.

On the investor side, bond ratings provide important information about the riskiness of various investments. Knowing a company’s and bond’s ratings can help investors determine how much risk they are willing to take on and whether the promised returns are worth the risks.

Whether you are only comfortable purchasing investment-grade bonds or you are willing to take a calculated risk by purchasing junk bonds, having the ratings assigned by the agencies provides another important metric you can use to decide which investments are right for you.

Criticism of Bond Rating Agencies

Though having access to these bond ratings can be very helpful to investors, they are not without flaws. To start, bond rating agencies are privately owned companies, and bond issuers pay the agencies to rate them. This presents a potential conflict of interest, and investors should always keep this fact in mind when using information from rating agencies. Many experts advise investors to use ratings as just one piece of information for deciding where to invest, rather than the only piece of information.

Additionally, since the methodology for rating securities and their issuers is proprietary, it is not always clear why and how the agencies assign their ratings. For example, S&P Global Ratings downgraded the United States federal government’s credit rating for the first time in 2011 in response to the debt-ceiling crisis. Because of this decision by S&P, global markets declined the following trading day after the announcement, even though the country showed no sign of default in the following decade.

The evaluation methodology used by rating agencies may also fail to foresee coming problems, as happened in 2008. Each of the three major rating agencies gave high ratings to the kinds of mortgage-backed securities that proved to be far riskier than their ratings indicated. Investors who trusted in these ratings were often then overexposed to securities that contributed to the housing bubble correction that year.