Question

What are the three major rating agencies? What are some criteria that the rating agencies use when assigning ratings? What impact do bond ratings have on the cost of debt to the issuing firm?

Answer 1

• The Big Three Credit rating agencies are Standard & Poor's (S&P), Moody's, and Fitch Group. S&P and Moody's are based in the US, while Fitch is dual-headquartered in New York City and London and is controlled by Hearst.

• The rating process employed by credit rating agencies may at times appear opaque to many issuers. However, the major credit rating agencies(S&P, Moodys and Fitch Group) will be relatively consistent in their analysis because they largely examine the same criteria. Rating agencies tend to vary only in their weighting of the individual parts of the credit analysis.

  An issuer default rating or corporate rating (different rating agencies use different terminology) is first and foremost the assessment of an issuer’s ability to service debt obligations in time and in full. As the majority of debt instruments require the repayment of interest and principal over time, the credit analysis will Focus on the company’s ability to generate sufficient cash to fund business operations and service debt obligations. An issuer’s financial flexibility and capability to generate free cash flow from operations is therefore a key determinant of the credit rating.

  Depending on the type of business, credit ratings may be determined to a significant extent by the industry environment, industry risks and factors such as market position of the issuer. In this context agencies will compare the business and financial risks of the issuer relative to industry peers.

  For other companies, the individual business and financial profile of the issuer may be the governing criteria that affect the credit rating. Typically, the capability of the company to adapt to or cope with adverse business conditions is tested in a number of sensitivity analyses, for example, regarding interest rate risks.

  Rating agencies will assess the various criteria in isolation. Some agencies even assign individual scores to categories, such as business risks or the financial risk profile, before arriving at a final issuer rating. The rating of an individual debt issue will then be derived by applying structural considerations such as seniority of the debt, collateral, recovery in the event of default and other capital structure elements to the issuer rating.

• There is widespread misunderstanding about what credit ratings really mean, and how they affect the returns that you earn and the overall riskiness of your portfolio.

  Investors generally rely on bond ratings to evaluate the credit quality of specific bonds. Credit ratings indicate on a scale of high to low the probability of default; that is, the probability that debt will not be repaid on time in full. Failure to redeem principal at maturity would constitute a default. Failure to make interest payments on time (that is, to pay coupons to bondholders) would also constitute a default.