Rating Agencies

Rating agencies are companies that assess the financial strength of other companies and governments, essentially judging their ability to pay back their debts. Their most famous product is the credit rating, a simple letter grade (like a report card for debt) that tells investors how likely an entity is to default on its loans. The big players in this field, often called the “Big Three,” are Moody's, Standard & Poor's (S&P), and Fitch Ratings. Together, they control about 95% of the global market. These ratings are incredibly influential; a good rating can allow a company to borrow money at a lower interest rate, while a bad one can make borrowing expensive or even impossible. For investors, these ratings have long been a go-to shortcut for judging the safety of an investment, particularly for bonds. However, as we'll see, relying solely on these agencies can be a recipe for disaster.

Imagine a company, “MegaCorp,” wants to borrow a billion dollars by issuing bonds. To attract investors, MegaCorp needs to prove it's a safe bet. This is where the rating agencies come in.

MegaCorp hires and pays a rating agency like S&P to analyze its business. The agency's analysts dive deep into MegaCorp's finances. They scrutinize its balance sheet, cash flow, debt levels, and profit margins. They also look at broader factors like the health of MegaCorp's industry, the quality of its management, and its competitive position. After this exhaustive analysis, the agency assigns a credit rating. If MegaCorp gets a shiny “AAA” rating, investors will flock to its bonds, confident they'll get their money back. If it gets a lowly “B” rating, investors will demand a much higher interest rate to compensate for the perceived risk.

Here's the catch that every investor needs to understand: the company or government being rated is also the one paying the agency's fee. This is known as the issuer-pays model. This creates an obvious conflict of interest. Think about it: if an agency is too harsh, the issuer might take its business to a more “understanding” competitor next time. This creates a powerful incentive for agencies to be lenient, a problem that came to a spectacular and catastrophic head during the 2008 subprime mortgage crisis.

The rating scales used by the “Big Three” are broadly similar, though the letters might differ slightly. They are generally split into two main categories.

These are ratings given to entities considered to have a low risk of default. Many pension funds and insurance companies are only permitted to own bonds with these ratings.

• S&P / Fitch: AAA, AA, A, BBB
• Moody's: Aaa, Aa, A, Baa

Think of these as the A and B students of the financial world. They are generally reliable and safe, but they offer lower returns.

These are ratings for entities with a higher risk of default. Because of the increased risk, their bonds must offer much higher interest rates to attract investors. They are often called junk bonds.

• S&P / Fitch: BB, B, CCC, CC, C, D (for Default)
• Moody's: Ba, B, Caa, Ca, C

These are the C and D students. They might offer the thrill of high returns, but there's a real chance you won't get your money back.

For a value investor, the word of a rating agency is never the final word. It's a starting point for investigation, but a poor substitute for independent thought.

The 2008 financial crisis is the ultimate proof of the agencies' fallibility. In the years leading up to the crash, agencies handed out top-tier AAA ratings to complex financial products backed by incredibly risky subprime mortgages. They were paid handsomely to do so. When the housing market turned, these “ultra-safe” investments imploded, triggering a global financial meltdown. This debacle severely damaged the agencies' reputations and taught investors a painful lesson: never outsource your thinking.

The legendary investor Warren Buffett has said he reads the agencies' reports but always, without exception, does his own credit analysis. He understands that a rating is just an opinion—an opinion from a party with a potential conflict of interest. A true value investor uses ratings strategically:

• As a First Screen: Ratings can be a quick way to filter a vast universe of bonds into a more manageable list. You might use them to screen out the most obvious garbage, but not to screen in your final investment choices.
• To Hunt for Opportunity: When a company is downgraded, panic often sets in, and its bond prices can plummet. This can create a buying opportunity for a diligent investor who, after doing their own research, concludes the market has overreacted and the company is still fundamentally sound.
• As a Contrarian Indicator: If everyone, including the rating agencies, loves a particular company or industry, a value investor's skepticism should be on high alert. Widespread optimism often leads to inflated prices and overlooked risks.

Ultimately, the key is to remember what a rating is: a third-party opinion. It's not a guarantee, and it's certainly not a replacement for rolling up your sleeves, reading the annual reports, and forming your own judgment about a business's long-term prospects.