Credit ratings

This week, we take a break from our investing principles series to take a look at credit ratings. We think this is timely, given the debate around the downgrade of the United States' long-term credit rating.

Credit ratings agencies (CRAs) are private profit-oriented entities that issue an opinion on the likelihood a borrower will default on its debt.

The opinion is issued in the form of a letter grade, with AAA being the highest rating. Investors typically think of the ratings as being divided into two classes, investment grade or non-investment grade (junk).

Bonds with an investment-grade rating are seen as being relatively safe, while those with non-investment grade ratings are seen as relatively risky. Using the Standard and Poor's scale, a rating of BBB or better is considered investment grade and below BBB is considered non-investment grade.

Much of the power of the CRAs seems to come from the fact that the credit opinions - ratings - they issue have been written into the law and contracts in many countries. For example, by law or contractual agreement many institutions are only allowed to invest in financial instruments carrying an investment grade credit rating by one of the major agencies.

Also, in many instances, contracts require that financial instruments posted as collateral have a AAA rating. Thus attaining and maintaining a particular credit rating can have important consequences for a borrower.

An investment-grade or better credit rating gives a borrower access to a larger pool of lenders and lower borrowing costs, while the reverse is also true.

The credit-rating industry is dominated by Moody's Investors Services and Standard & Poor's, with Fitch running a distant third.

The CRAs were much maligned for assigning AAA ratings to now worthless sub-prime mortgage loans, and infamously rating Enron as 'Investment Grade' in the same week the company filed for bankruptcy.

justin.robinson@cavehill.uwi.edu