Cool it with credit ratings critiques

Lambasting credit rating agencies is a favourite pastime of many debt market participants.

- Marty Fridson

However, self-interest appears to drive many of the most common criticisms, and history suggests these much-maligned appraisers actually do a pretty good job.

Credit ratings agencies, such as Moody's Investors Service, S&P Global, and Fitch Ratings, assign a letter grade to a company or security indicating the default risk. A triple-A rating denotes the lowest risk, while a triple-C rating suggests that the debt in question has a good chance of falling into arrears.

One classic criticism of these agencies is that their assessments are contaminated by a conflict of interest because the bond issuers pay to be rated.

But one will struggle to find any evidence of such bias in corporate bond ratings.

Others might point to the Enron debacle in 2001, when the company was rated investment grade just before it went bankrupt, to suggest that the ratings process must be flawed.

However, the rating agencies make their assessments based on issuers’ audited financial statements, and Enron’s implosion occurred because of the company’s fraudulent financial reporting.

Another common knock is that this reliance on past financial results means ratings agencies, unlike the market, are backward-looking, but agencies’ assessments absolutely do incorporate projections of companies’ future financial results — just like market analysts.