The Rating Agencies
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Three companies dominate the global credit rating industry:
- Moody's Investors Service, founded in 1909 by John Moody, who published the first systematic ratings of railroad bonds.
- Standard & Poor's (S&P), which traces its bond rating history to 1916 and was formed through the merger of Standard Statistics and Poor's Publishing.
- Fitch Ratings, the smallest of the three major agencies, founded in 1913 by John Knowles Fitch.
Each agency assigns a letter-grade rating to bonds, reflecting the agency's assessment of the likelihood that the issuer will meet its payment obligations. The scales differ slightly:
| Quality | Moody's | S&P / Fitch |
|---|---|---|
| Highest | Aaa | AAA |
| High | Aa | AA |
| Upper medium | A | A |
| Lower medium | Baa | BBB |
| Speculative | Ba | BB |
| Highly speculative | B | B |
| Very high risk | Caa | CCC |
| Default | C / D | D |
The critical threshold is between Baa3 (Moody's) / BBB- (S&P) and the next rung down. Above this line is investment grade; below it is high yield (sub-investment grade). This threshold has regulatory and institutional significance: many pension funds and insurance companies are restricted by mandate from holding sub-investment grade bonds. A downgrade across this line — a "fallen angel" — can force mass selling and drive yields sharply higher.
Ratings vs Market Prices
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Formal credit ratings are backward-looking by nature: agencies analyse financial statements, interview management, and update ratings periodically. The yield spread — the excess yield a bond pays above the government rate — is a market-based, real-time assessment of credit risk. Because it reflects the continuous judgements of buyers and sellers with money at stake, spread movements often lead formal rating changes by weeks or months.
The CDS (credit default swap) market provides an even purer expression of credit risk. A CDS is essentially insurance against a bond default: one party pays a regular premium, and the other pays out the face value if the issuer defaults. The CDS premium (spread) is quoted in basis points per year and moves in real time. CDS markets exist for both individual corporates and for sovereign governments.
The 2008 Crisis and Rating Agency Criticism
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The 2007–2008 financial crisis produced a severe indictment of the rating agencies. Vast quantities of structured credit products — in particular collateralised debt obligations (CDOs) backed by US subprime mortgages — were assigned AAA ratings, the highest available. When the underlying mortgages began defaulting, many of these AAA-rated instruments became nearly worthless almost overnight.
The criticism focused on two structural problems:
- The issuer-pays model: rating agencies are paid by the issuers whose bonds they rate, creating a conflict of interest. Issuers could shop for favourable ratings, and agencies had commercial incentives to maintain relationships with large, frequent issuers.
- Model failures: the statistical models used to rate structured products assumed that US house prices could not fall simultaneously across all geographies — an assumption that proved catastrophically wrong.
Post-2008 reforms included the Dodd-Frank Act provisions requiring greater transparency and accountability from rating agencies, though the fundamental issuer-pays conflict of interest has never been fully resolved.