What it means
A credit rating is an independent opinion on creditworthiness, shown as a letter grade such as AAA or BBB. Higher ratings signal lower risk of default and generally lower borrowing costs, while lower ratings signal higher risk and higher interest rates.
Companies, governments and issuers of structured securities pay agencies to rate their debt. The NRSRO designation was created by the SEC in the 1970s so that regulators could refer to ratings from agencies they considered credible.
Congress passed the Credit Rating Agency Reform Act in 2006, which set a formal registration process and gave the SEC oversight powers. Registered agencies must follow rules on conflicts of interest, record keeping and disclosure of methods, and they are inspected by the regulator from time to time.
The three best-known agencies, S&P Global Ratings, Moody's and Fitch, are NRSROs, and several smaller firms are as well. Each agency registers for specific categories of ratings, such as corporate issuers, financial institutions, governments or asset-backed securities, so an agency may be an NRSRO for some types of debt but not others.
After the 2008 financial crisis, when highly rated mortgage securities suffered heavy losses, regulators tightened oversight and reduced the number of rules that required ratings. The aim was to stop investors treating a rating as a substitute for their own analysis, though many contracts and investment policies still refer to NRSRO ratings.
For managers, the key point is that ratings drive financing costs. A company that is downgraded may face higher interest rates, stricter loan terms or exclusion from investors that can only hold highly rated debt.
Understanding what the agency looks at helps a finance team prepare for a rating review. Agencies typically look at business strength, leverage, cash flow, liquidity and the issuer's financial policies.
They also compare the issuer with peers and consider the legal terms of the debt, such as security and ranking in a default. A rating is therefore a view on the specific borrower or instrument, not on the company's products or reputation.
In practice
Real-world examples.
Example
A manufacturer plans to issue $200,000,000 of bonds. Its treasurer meets an NRSRO analyst to explain the firm's cash flow and debt plans, hoping to secure a rating that pushes the interest cost lower.
Example
A pension fund's investment policy says it may only buy corporate bonds rated at least BBB by an NRSRO. The fund manager removes a bond from the portfolio after a downgrade to BB. She records the sale in the compliance log with the date of the rating action.
Example
A city government preparing to borrow for a new hospital pays an NRSRO to rate its bonds. A strong rating lets it sell the bonds at a lower interest rate and save taxpayers money. The saving over the life of the bonds runs into millions of dollars.
Case study
Seen in the real world.
Eastgate Energy is an illustrative, fictional utility company planning to refinance $500,000,000 of debt. Its chief financial officer discovered that one of its lenders could only hold debt rated investment grade by an NRSRO.
An agency review flagged high leverage and weak cash flow, and signalled a downgrade to just below investment grade. The lender's policy would then have forced it to sell the debt. The company sold two non-core assets, used the $120,000,000 proceeds to cut debt and presented a clear plan to the agency, including a pledge to keep borrowing within a stated limit.
In this illustrative story the rating stayed at investment grade and the refinancing went ahead at a lower interest rate. The case shows how directly an agency's judgement shapes a company's financing options. Eastgate now briefs the agency every year, not only when it plans to borrow.
Watch out
Common mistakes.
- Treating an NRSRO rating as a guarantee, when it is an opinion that can be wrong.
- Assuming all rating agencies are NRSROs, when only those registered with the SEC hold the status, and only for the categories they register in.
- Believing a rating is permanent, when agencies review and change ratings as conditions evolve.
Questions
People also ask.
Who designates NRSROs?
The US Securities and Exchange Commission registers and oversees them. Registration is by category of rating, such as corporate or government issuers.
Who pays for the ratings?
In most cases the issuer of the debt pays the agency, which is why conflict of interest rules exist. Some agencies instead charge investors for their research.
Which agencies are the largest?
S&P Global Ratings, Moody's and Fitch are the best known, although several smaller agencies also hold the status. Check the regulator's list for the current registrants and their categories.
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