As part of the masterclass “Be a Trader,” international rating agencies increasingly influence global market sentiment. It’s common to see news headlines about the downgrade of a country’s or company’s credit rating. However, many traders who mention names like Fitch, S&P, or Moody’s often don’t fully understand what credit ratings are, how they’re formed, and how they function. So, what exactly is a credit rating?
The Beginning of Rating Agencies
The history of rating agencies began in the second half of the 19th century in the United States during the rapid expansion of railroad construction, which was funded by foreign investors. The Bank of England issued an ultimatum to the U.S. Treasury. British investors were willing to fund railroad construction only after receiving reports from independent experts showing the financial condition of railroad companies.
To solve this issue, representatives of the Treasury turned to Henry Poor, the editor-in-chief of the American Railroad Journal. Based on questionnaires sent to the leaders of 120 railroad companies, Henry Poor essentially created the first credit rating. Later, with his son, Poor founded a publishing house that eventually became the famous agency Standard & Poor’s.
In 1909, John Moody published a book on securities, where he first used a letter code to denote risk levels, and later founded his own agency, now known as Moody’s.
In 1913, the Fitch agency was established by John Knowles Fitch. It was Fitch that introduced the letter rating scale in 1924, which is now known worldwide.
The existence of the so-called “Big Three”: Fitch IBCA, Standard & Poor’s, and Moody’s was officially recognized in 1974 after the U.S. Securities and Exchange Commission (SEC) approved the list of “recognized national rating agencies.” Major American pension and insurance funds could now only purchase securities with investment ratings assigned by one of these agencies.
American rating agencies began appearing on foreign markets in the late 1980s. Despite the emergence of regional competitors (there are currently around 150), Fitch IBCA, Standard & Poor’s, and Moody’s quickly grew from a national “Big Three” to a global presence, leaving local agencies with just about 6% of the global credit rating market. Fitch joined the “Big Three” in 2000 after acquiring Thomson BankWatch (banks and sovereign ratings) and Duff & Phelps Loan Rating Co. (structured product ratings).
Credit Ratings in Peace and War Time
Formally, a credit rating is a method of grading issuers (countries, companies, etc.), indicating the likelihood of failing to meet their debt obligations in domestic or foreign currency over a certain period.
To better understand how credit ratings work, we can conditionally divide the state of the global economy into “peace” and “war” time.
In “peace” time, credit ratings serve as a screening tool for acceptable investment volumes and limitations on investments. Traditionally, most foreign investment funds require a credit status no lower than a certain threshold. Central banks also have similar requirements for inclusion in discount lists: the lower the credit rating, the higher the discount. It’s important to understand that in such cases, a credit rating, especially a sovereign one, serves as an assessment of the ability to fulfill debt obligations, not as an indicator of economic growth potential or investment opportunities.
For example, a country that extracts all its economic resources to service external debt will have a higher credit rating than a country using foreign investments for infrastructure development. In the list of corporate borrowers, S&P gives the highest credit rating to only four companies, not necessarily the strongest: ExxonMobil, Automatic Data Processing, Microsoft, and Johnson&Johnson. It’s worth noting the concept of the “sovereign ceiling”. This means that a company or bank’s rating cannot exceed the sovereign rating of the country where it operates or has its headquarters. In the past, Moody’s introduced a new banking rating system, under which Icelandic banks, which eventually declared default, had ratings exceeding the sovereign rating due to the globalization of their business. Subsequently, this banking rating system was revoked.
The function of the credit rating system becomes much more interesting in “war” time, during crisis situations when investor capital starts to flee to quality. In such conditions, the difference between credit rating groups becomes very important. Often, investors and financial regulators criticize rating agencies for delayed downgrades of non-payable countries and companies. A classic example is Enron, which lost its investment-grade rating (above BBB-) just four days before declaring bankruptcy. Investors still remember the manipulation of Greece’s credit rating, which fell “below the floor,” somewhat undermining the credibility of rating agencies. Interestingly, in the case of partial failure to meet debt obligations, S&P uses a special SD rating, indicating selective default, which was introduced in 1998 for Russia.
Opportunity Exists, But Will Is Missing
The reasons behind these credit anomalies can be understood. One thing is assessing the solvency of a country or company and their financial condition. In this case, rating agencies can do it quite adequately, excluding cases of data manipulation by the issuer, as seen in the cases of Greece and Enron. Another challenge is assessing the willingness to pay debts, which often depends on political processes within the country or personal factors if it involves companies. More importantly, it’s hard to expect a stricter approach to evaluation while rating agencies are funded by the issuers themselves. Special fees from issuers, attempts to rotate rating agencies, and other measures to shift funding to investors due to organizational challenges have not yet been implemented.
There are also cases where the credit rating is influenced more by the popularity of the country or company than by their actual solvency, or their ability to challenge a rating agency’s decision.
In conclusion, the experience of existing financial crises calls for careful consideration of credit ratings and filtering the data provided by rating agencies. Correctly evaluating the willingness of an issuer to meet debt obligations and the ability to impose appropriate restrictions based on rating agency decisions, rather than blindly following them, is a distinguishing feature of successful investors.
FAQ
What is a credit rating?
A credit rating is a measure of an issuer’s ability to meet its debt obligations, used by investors to assess risk.
How are credit ratings determined?
Credit ratings are determined by analyzing the financial health, stability, and willingness of an issuer to repay debts, often conducted by independent rating agencies.
Why do credit ratings matter for traders?
Credit ratings affect market sentiment, investment decisions, and the cost of borrowing. They help traders assess risk and make informed choices.
