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Understanding Credit Rating Agencies

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Credit ratings provide individual and institutional  investors with information that assists them in determining whether issuers of  debt obligations and fixed-income securities will be able to meet their  obligations with respect to those securities. Credit rating agencies provide  investors with objective analyses and independent assessments of companies and  countries that issue such securities. Globalization in the investment market,  coupled with diversification in the types and quantities of securities issued,  presents a challenge to institutional and individual investors who must analyze  risks associated with both foreign and domestic investments. Historical  information and discussion of three companies will facilitate a greater  understanding of the function and evolution of credit rating agencies.

The Big Three  credit rating agencies are Standard & Poor’s, Moody’s Investor Service, and  Fitch Ratings.  Moody’s and S&P each  control about 40 percent of the market. Third-ranked Fitch Ratings, which has  about a 14 percent market share, sometimes is used as an alternative to one of  the other majors

Fitch Ratings
John Knowles Fitch founded the Fitch Publishing Company in 1913. Fitch  published financial statistics for use in the investment industry via “The  Fitch Stock and Bond Manual” and “The Fitch Bond Book.” In 1924,  Fitch introduced the AAA through D rating system that has become the basis for  ratings throughout the industry. With plans to become a full-service global  rating agency, in the late 1990s Fitch merged with IBCA of London, subsidiary  of Fimalac, S.A., a French holding company.  Fitch also acquired market competitors Thomson BankWatch and Duff & Phelps  Credit Ratings Co. Beginning in 2004, Fitch began to develop operating  subsidiaries specializing in enterprise risk management, data services and  finance industry training with the acquisition of Canadian company,  Algorithmics, and the creation of Fitch Solutions and Fitch Training.

Moody’s Investors Service
John Moody and Company first published “Moody’s Manual” in 1900. The  manual published basic statistics and general information about stocks and  bonds of various industries. From 1903 until the stock market crash of 1907,  “Moody’s Manual” was a national publication. In 1909 Moody began  publishing “Moody’s Analyses of Railroad Investments”, which added  analytical information about the value of securities. Expanding this idea led  to the 1914 creation of Moody’s Investors Service, which, in the following 10  years, would provide ratings for nearly all of the government bond markets at  the time. By the 1970s Moody’s began rating commercial paper and bank deposits,  becoming the full-scale rating agency that it is today.

Standard & Poor’s
Henry Varnum Poor first published the “History of Railroads and Canals in  the United States”  in 1860, the forerunner of securities analysis and reporting to be developed  over the next century. Standard Statistics formed in 1906, which published  corporate bond, sovereign debt and municipal bond ratings. Standard Statistics  merged with Poor’s Publishing in 1941 to form Standard and Poor’s Corporation,  which was acquired by The McGraw-Hill Companies, Inc. in 1966. Standard and  Poor’s has become best known by indexes such as the S&P 500, a stock market  index that is both a tool for investor analysis and decision making, and a U.S.  economic indicator.

An Overview of Credit Ratings
Countries are issued sovereign credit ratings. This rating analyzes the general  creditworthiness of a country or foreign government. Sovereign credit ratings  take into account the overall economic conditions of a country including the  volume of foreign, public and private investment, capital market transparency  and foreign currency reserves. Sovereign ratings also assess political  conditions such as overall political stability and the level of economic  stability a country will maintain during times of political transition.  Institutional investors rely on sovereign ratings to qualify and quantify the  general investment atmosphere of a particular country. The sovereign rating is  often the prerequisite information institutional investors use to determine if  they will further consider specific companies, industries and classes of  securities issued in a specific country.

Credit ratings, debt ratings or bond ratings are issued to individual companies  and to specific classes of individual securities such as preferred stock,  corporate bonds and various classes of government bonds. Ratings can be assigned  separately to short-term and long-term obligations. Long-term ratings analyze  and assess a company’s ability to meet its responsibilities with respect to all  of its securities issued. Short-term ratings focus on the specific securities’  ability to perform given the company’s current financial condition and general  industry performance conditions.

The highest ranking accorded to any bond is AAA. The three  major credit ratings agencies all use that three-letter code to denote that a  bond is as safe as any bond can be.

A chart of the codes used by the three major agencies can be  found here.

Moody’s ranks bonds with the following codes: Aaa, Aa, A,  Baa, Ba, B, Caa, Ca, C. Fitch and S&P use these codes: AAA, AA, A, BBB, BB,  B, CCC, CC, C, D.

Investors may utilize information from a single agency or from multiple rating  agencies. Investors expect credit rating agencies to provide objective  information based on sound analytical methods and accurate statistical  measurements. Investors also expect issuers of securities to comply with rules  and regulations set forth by governing bodies, in the same respect that credit  rating agencies comply with reporting procedures developed by securities  industry governing agencies. Understanding the history and evolution of ratings  agencies gives investors insight on the methodology that agencies use, as well  as the quality of ratings from each agency. The analyses and assessments provided  by various credit rating agencies provide investors with information and  insight that facilitates their ability to examine and understand the risks and  opportunities associated with various investment environments. With this  insight, investors can make informed decisions as to the countries, industries  and classes of securities in which they choose to invest.

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