Credit Rating

Credit Rating: Opinions offered by Credit Rating Agencies about the credit risk incurred in the course of investing in a firm’s bond issues. They concern both the willingness and the capacity of a company to meet its financial obligations as they fall due and thus the relative likelihood of a corporate default event.

Use Of Credit Rating For Traders

Used by investors to try to better understand a company’s credit profile, they are predominantly provided by 3 credit rating firms, namely:

  • Moody’s
  • S&P
  • Fitch

(though there are other, smaller rating firms).

Although they use different rating scales, (Moody’s will use Aaa, whereas S&P uses AAA to designate a top-grade credit), they are readily comparable.

Issues

The problems of relying on a credit rating centre on two issues.

Firstly, it is inherently probabilistic, as it depends on an accurate forecast of what may happen in the future.

Opinions (arising from differing assumptions embedded in their ratings models), can therefore differ, sometimes widely, on how strong a firm (or structured product) actually is.

Secondly, there lies a huge potential conflict of interest in the fact that issuers themselves pay for ratings agencies to evaluate their bonds etc.

As was discovered during the Mortgage Crisis of 2007-09, agencies themselves were forced to compete with each other to get business, which results in a “race to the bottom”, whereby firms were prepared to rate an issue that would ordinarily below investment grade as top grade (i.e. AAA) in order to maintain market share.

A significant amount of sub-prime debt was being assessed as low risk, which only came to light when the mortgage market collapsed.

Even when this process was well under way, they were extremely slow to adjust their opinions downwards, to avoid loss of business from their issuers.

In addition, far too many investors relied solely on the ratings agencies, without doing their own due diligence on the products being offered by Wall Street banks.

Despite much criticism of the “issuer pays” model neither the SEC nor the Fed have made any progress in forcing the industry to reform this practise.