How Financial Markets Work: Behind the Scenes
How Credit Ratings Work
What credit rating agencies do, what letter grades like AAA and BBB mean, and why ratings matter for governments, companies and investors.
When a government or company borrows by selling bonds, investors want to know how likely it is to repay. Credit rating agencies assess this risk and assign grades.
The main agencies
Three agencies dominate the global market: S&P Global Ratings, Moody’s and Fitch Ratings. In India, agencies such as CRISIL, ICRA and CARE rate Indian companies and financial products.
The rating scale
Ratings use letter grades. On the S&P and Fitch scales:
- AAA: the highest rating, extremely strong capacity to repay.
- AA and A: very strong to strong.
- BBB: adequate. BBB minus is the lowest investment grade rating.
- BB and below: speculative, often called “junk” or high yield.
- D: in default.
Moody’s uses a similar scale with different labels, such as Aaa and Baa.
Why ratings matter
- Borrowing costs: lower ratings usually mean higher interest rates, because investors demand compensation for greater risk.
- Investment rules: many pension funds, insurers and other institutions can only buy investment-grade bonds. A downgrade below that line can force them to sell.
- Country ratings: sovereign ratings for governments affect not only government borrowing costs but often those of companies in the country.
A company rated BBB minus is downgraded to BB plus, crossing below investment grade. Some funds must sell its bonds, pushing their price down and yields up. The company's future borrowing becomes more expensive. This "cliff" effect is why companies work hard to keep investment-grade ratings.
Criticism
Rating agencies were heavily criticised after the 2008 financial crisis for giving top ratings to mortgage-backed securities that later collapsed. A key concern is the issuer-pays model: the organisations whose bonds are rated pay the agencies, creating a potential conflict of interest. Regulators have since increased oversight. Governments have also criticised agencies, arguing that sovereign ratings can be slow, pro-cyclical or unfair to developing countries.
A rating is an opinion about the likelihood of repayment, not a promise. Highly rated borrowers can still default, as the collapse of many AAA-rated mortgage securities in 2008 showed. Ratings are one input to investment decisions, not a substitute for judgement.
- Credit rating agencies assess the risk that a borrower will not repay.
- S&P, Moody's and Fitch dominate globally; CRISIL, ICRA and CARE are major in India.
- BBB minus is the lowest investment-grade rating; below it is speculative.
- The issuer-pays model and the 2008 crisis raised concerns about conflicts of interest.
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