The Role of Credit Rating Agencies in Financial Markets

Credit rating agencies (CRAs) are private organizations that apply letter ratings to individual debt securities and their respective issuers. These issuers will include publicly traded corporations, insurers, and sovereign governments. Credit ratings directly influence capital flows through the global marketplace.

NRSROs

The Securities and Exchange Commission (SEC) identifies ten Nationally Recognized Statistical Rating Organizations (NRSROs). NSROs register with the Commission to rate credit for sale in the United States. We identify Fitch, Moody’s, and Standard & Poor’s as the Big Three for their dominance above this industry. As a group, the Big Three controls 95% of the credit-rating market.  

Security Analysis

Credit rating agencies classify corporations and government agencies according to their perceived ability to make good on interest and principal payments. Security analysts will take profitability, free cash flow, corporate structure, and inventory turnover into account before applying ratings.

Municipalities are judged according to their ability to support economic growth, collect taxes, and pass reasonable legislation. The popularity of Bitcoin and crypto currency is in direct response to towering budget deficits, which investors fear will never be repaid.   

Credit Ratings

Conservatively managed institutions with minimal debt levels and strong cash reserves are friendly to bondholders and receive the highest AAA ratings. Johnson & Johnson and Microsoft are now the only AAA-rated corporations in the S&P 500.

Alternatively, high-debt levels and deteriorating economics are cause for credit downgrades. Non-investment grade BB, or junk debt, is associated with firms at the precipice of bankruptcy. Junk debt sells for pennies on the dollar and pays out high yield – to compensate investors for taking on more financial risks.  

For generations, it was the United States that represented the gold standard in credit, for its power to tax and create money. In 2011, the U.S. briefly lost its AAA rating amid a brutal, legislative fight to raise the debt ceiling.

At that time, Apple Computer could tap the credit markets and borrow more cheaply than the Federal Government. Apple went on to plow its cheap debt into buying back stock. Apple has retired more than eleven billion shares, or nearly half, of all outstanding common stock over the past decade.    

Financial Strategies

Investors rely upon bond ratings to confirm their own analyses and trade accordingly. Conservative savers prioritize safety of principal and will gravitate towards AAA debt. Insurers, pensions, and money market mutual funds often times restrict themselves to only purchasing investment-grade securities.   

Aggressive investors prefer to speculate in junk debt, while knowing that creditors are to be paid first before stockholders. In 2009, Warren Buffett himself turned a tidy profit by lending money out to Harley-Davidson at 15%. 

CRA Financial Risks

Credit rating agencies are not without controversy. The industry went under heavy fire amid the Great Recession. The entire financial sector was then in a state of near total collapse, despite firms being recently anointed with top ratings. Intelligent investors must recognize credit ratings as opinions, and not facts.  

The Moody’s, S&P, and Fitch Big Three CRAs, again, control 95% of this market, which demands large amounts of capital and a sterling business reputation. Warren Buffett would describe these high barriers of entry as a moat. The Oracle of Omaha does own nearly 25 million shares, or $10 billion in Moody’s stock.

At these levels of concentration, CRAs are prone to groupthink. Like clockwork, one major downgrade will have all major rating agencies immediately scrambling to match each other.  Be further advised that issuers pay the CRAs to rate securities and provide advice, which is an alarming conflict of interest. Now, credit rating agencies, like accountants, may draft positive opinions in order to keep business.

All investors must put in the work to complete their own research. A diversified stock and bond portfolio that features various geographies, industries, maturities, and ratings will help mitigate financial risks.