Credit rating agencies (CRAs) are a key part of fundamental analysis – and their actions can reverberate across financial markets. Learn all about what a credit rating agency does here.
- What are credit rating agencies?
- How does a credit rating agency work?
- Credit rating agencies’ rating scales
- The big three rating agencies
- Credit rating agency history
- Are rating agencies regulated?
What are credit rating agencies?
Credit rating agencies (CRAs) are independent companies that publish regular analysis on the ability of financial institutions to service their debts. These credit ratings have a major effect on the financial markets: chiefly bonds, but forex, stocks and indices as well.
The credit ratings issued by agencies tell you the level of credit risk associated with a particular entity – essentially how likely it is to default on its debts. They are best known when applied to the bonds issued by corporations and governments, but can also be applied to other assets too, such as preferred stock or mortgage-back securities.
CRAs have a hugely important role in the financial markets. The world’s largest economies, for example, run on huge levels of debt. If an agency downgrades its credit rating, then demand for their debt will fall, meaning the cost of servicing it goes up. This can have a serious effect on the economy.
How does a credit rating agency work?
A credit rating agency works by issuing a score to companies (corporate bonds) or governments (sovereign bonds) that issue debt securities. These scores take a wide variety of factors into account and tell you how likely the agency thinks it is that the issuer will default on the debt.
Credit ratings are generally split into two categories, investment grade and speculative:
- Investment grade means that a security has a high credit rating. These assets are viewed as very safe, but may not pay a high return
- Speculative (or junk) means that a security has a low credit rating. These assets are viewed as riskier and may pay a higher return to compensate
CRAs typically have analysts who recommend which rating to give a security. They’ll research economic and fundamental data in order to make their decision – which data depends on the security being analysed. An analyst examining a sovereign bond, for instance, might look into the country’s political situation, incoming investment, currency reserves and more.
Once the analyst has made a recommendation, it’ll go before a committee to vote on whether to use the rating.
Credit rating agencies' rating scales
All the major credit ratings agencies use an alphabetical scale in their credit scores – with AAA being the top rating and C or D at the bottom. However, within the scales themselves there is some differentiation, which we go into in more detail below.
Institutions with a AAA rating are seen as extremely unlikely to default on their debts. Generally, it is taken that a AAA rating means a less than 1% likelihood of a default.
The three biggest credit rating agencies
Together, the ‘big three’ credit ratings agencies – Moody’s, Standard & Poor’s and Fitch – control around 95% of the market. They have been accused of holding an oligopoly over the ratings industry in both the US and Europe. In Asia, the market is more diversified.
Moody’s Investors Service – better known simply as Moody’s – was founded by John Moody at the beginning of the 20th Century. Initially focussing only on the bonds issued by flourishing railroad companies, today it is the joint-biggest agency by market share alongside Standard & Poor’s. Both control around 40% of the market.
The ratings provided by Moody’s are slightly different to those by S&P and Fitch. From highest rating to lowest, they are:
Anything above Ba1 is classed as investment grade, Ba1 and below is classed as speculative. Ca means an institution is likely already in default, whereas a C rated institution is default with little chance of recovering capital.
Countries with an AAA rating from Moody’s include Canada, Norway and the United States. Currently only three companies have a AAA rating: Fannie Mae, Johnson & Johnson and Microsoft.
Standard & Poor’s
Standard & Poor’s (S&P) also has a long history – Henry Poor started publishing stock analysis in the 1860s, and Standard Statistics published ratings from 1906. The two companies merged in 1941, forming the S&P we know today.
Credit ratings are provided by S&P Global Ratings, a subsidiary of the main company S&P Global – best known as the provider of the S&P 500 index. Both S&P and Moody’s are present on the index and listed on the New York Stock Exchange (NYSE).
S&P’s ratings are as follows:
Anything above BB+ is rated as investment grade, anything BB+ or below is speculative grade. SD or D means a borrower has already defaulted on their financial obligations.
Countries with a AAA rating from S&P include Canada, Norway and Australia. In early 2023, the US lost its AAA rating and is now AA+. Johnson & Johnson and Microsoft are also rated AAA by S&P.
Fitch is the final ‘big three’ rating agency, although it is much smaller than the other two – controlling around 15% of the market. It is also private, so doesn’t feature on the NYSE or S&P 500. Fitch is headquartered in both New York and London.
Founded in 1924, Fitch ratings first introduced the AAA to D system which is still used today. Its rating system is largely identical to S&P’s:
As with S&P, AAA to BBB is investment grade, while BB down is speculative grade. As of September 2023, no companies had a AAA rating from Fitch, while only a handful of countries had one: including Norway, Australia and Germany.
Credit rating agencies UK
The only partially UK-based major credit ratings agency is Fitch, which has dual headquarters in New York and London. However, all of the big three cover securities in the UK.
Sometimes, in the UK a credit rating agency refers to a company that gives credit ratings to individuals instead of corporations and governments. Examples of these companies include Experian and Equifax.
History of credit rating agencies
Formation of credit agencies
Credit rating agencies were first formed in the United States in the 19th Century, as a response to the growing distances between investors and businesses – which made trustworthy information on businesses’ creditworthiness crucial.
In the 1900s, railroad bonds saw many of the first credit ratings issued and gave the US a much bigger bond market than other countries. Henry Varnum Poor and John Moody started their CRAs as a direct response to this trend.
NRSROs in the 1970s
Over the course of the 20th Century, credit rating agencies – chiefly the big three – grew in importance as investors recognised the clear benefit of independent financial analysis. By 1975, the Security and Exchange Commission began officially recognising the businesses.
This was also a period of stricter capital requirements from the SEC – which could be softened by investing in a security with a high rating from a ‘nationally recognized statistical rating organization’ (NRSRO). At first, the only NRSROs permitted by the SEC were the big three, although eventually this was widened.
Credit rating agencies and the 2008 global financial crisis
The power of CRAs was diluted slightly after the 2008 financial crisis, in which the big three were accused of incorrectly giving highly risky securities high ratings. Some mortgage-backed securities (MBSs), for example, had AAA ratings shortly before the market collapsed.
This came after a few notable scandals surrounding ratings, such as multiple investors suing CRAs after the collapse of Enron a few years earlier.
Are credit rating agencies regulated?
Credit rating agencies are regulated in the US by the SEC due to the Credit Rating Agency Reform Act of 2006. This was followed by the Dodd-Frank Act in 2010, which gave the SEC further power to regulate CRAs as a reaction to the fallout from the 2008 global financial crash.
Award-winning platforms, competitive spreads, low commissions and dedicated support.
We live and breathe the markets. For over 20 years, we've helped traders realise their ambitions and continue to set the industry bar.