Rating agencies help us understand the health of an economy or an institution. Let’s see what they are and why their decisions are so important.
What are rating agencies? What are their ratings for and why are their ratings so important?
In recent years, rating agencies seem to be all over the place. We often hear that a certain rating agency has cut its outlook estimates or downgraded a country’s or banking institution’s debt rating.
Themes that are now on the agenda, but we do not always fully understand them.
To overcome these problems, Money.it explains in detail below which are the main rating agencies, how they operate and why their estimates are so important.
Rating agencies: what they are and how they work
Rating agencies are intermediary institutions between the entities that issue equity securities (companies, governments, public companies) and investors (private or institutional). These agencies, carrying out data analyzes and examinations, try to understand what the value of a government bond or a bank is.
Rating agencies are entities that carry out financial research and analysis on equities and bonds. Their purpose is to assess financial stability, the subject of their analysis. And on the basis of the estimates that are provided, the shareholders move accordingly. This rating in fact determines the "credit worthiness" which is then classified on a standardized rating scale, namely the rating.
There are three best-known rating agencies, and they all have their main base in New York:
- Standard & Poor’s
- Moody’s
- Fitch
Moody’s Corporation began operations around 1900, when John Moody and associates published the "Moody’s Manual of Industrial and Miscellaneous Securities", which contained background information on a wide range of securities. Today, Moody’s Investor Service not only provides information, but also reports research, risk analysis and credit ratings of more than 106,000 structured finance bonds.
Fitch Ratings was founded by John Knowls Fitch in 1913, when he used to publish statistical analyzes in his "The Fitch Stock and Bond Manual". In 1924, the Fitch Publishing Company first introduced the AAA to D rating scale, which is still in use today. Today, Fitch Ratings provides services from its two offices in New York and London, as well as from its offices around the world.
Standard & Poor’s was born in 1941 from the merger of Standard Statistics with Henry Varnum Poor, editor of the "History of the Railroads and Canals of the United States", one of the first attempts to identify the financial background of the US railways. Today, S&P is not only known for issuing its judgments, but is highly regarded for its market indices, such as the S&P 500 and the S&P Case-Shiller property price index.
Other rating agencies such as DBRS and Egan-Jones have been trying to emerge since the start of the last financial crisis but, for now, have failed to attract the attention of market participants.
What is the rating?
Specifically, the rating is a judgment that expresses the reliability of a company, that is, its ability to repay a debt in a given period of time.
The rating is a sort of "grade" that agencies give to a specific entity, which can be public or private.
The assessment of the credit risk profile of an institution is based on a scale of values which summarizes the qualitative and quantitative information in a synthetic way going from AAA (rating attributed to institutions with low credit risk) to D (the credit for the entities thus assessed has "no probability of repayment").
Securities that have a very low rating are also called “junk bonds” (junk bond), since they have no value whatsoever.
The rating agencies rating scale
The evaluation that is drawn up is based on a scale of values and each wording has its own precise meaning. Based on the long-term rating, the scale of values goes:
- from AAA to BBB: positive evaluation which refers to investment grade.
- from BB to D: negative evaluation which refers to degree of non-investment.
| Evaluation | Meaning |
|---|---|
| AAA | Excellent quality of the body, maximum stability and reliability |
| AA | Stable body, but potentially exposed (it can do more, but it does not commit itself) |
| A | Entity whose financial capacity is in adverse economic conditions |
| BBB | Entity whose finances are currently satisfactory |
| B | Entity with a variable economic situation |
| CCC | Entity with vulnerable finances |
| CC | Highly Vulnerable Finance Entity |
| C | Entity that filed for bankruptcy |
| RD | The institution does not pay some commitments, but continues to pay other obligations |
| D | The institution is in bankruptcy, therefore it is insolvent |
The outlook from the rating agencies
Another evaluation tool is the outlook which, in financial jargon, indicates the medium and long-term forecast on a company, in the rating evaluation that precedes it.
We often hear that the rating agency has “cut the bank’s outlook”, which means that the agency has cut the growth estimates of the company being analyzed, since it does not foresee an improvement for that stock.
There are three possible options for the outlook: positive, negative, stable.
It follows that:
- if the outlook is positive, the future conditions of the company or country are expected to be better than or equal to the present;
- if the outlook is negative, worsening and further downgrading are foreseeable in the future;
- if the outlook is stable, no changes are expected, therefore, it is likely that the rating will not change in the future.
What are rating agencies for?
The rating agencies’ judgment is so important because, from their assessment, it follows the conditions for access to credit by the entities being rated. This is why it is the same companies, or bodies, or states that explicitly request evaluation from market agencies.
The rating determines the trend of the stock market and government bonds; any investor before buying a bond (which is like a credit, which the investor buys) needs an accurate analysis of the economic, financial and capital stability conditions of the entity whose securities he is buying.
The rating agencies essentially set out to do this: analyze, study and evaluate the financial conditions of an institution and provide investors with a tool to weigh their investment choices.
