Outline how rating agencies assign issue ratings and issuer ratings, and name the chief complaints made about those ratings.
The idea
An issuer rating, such as the S&P issuer credit rating, expresses an obligor's overall capacity to meet its financial obligations. An issue rating applies to a specific instrument and also reflects its seniority, collateral and expected recovery. Subordinated debt is therefore notched below the issuer rating and well-secured debt may be notched above it. Agencies combine quantitative analysis with qualitative judgement and committee review, and BBB- or Baa3 is the lowest investment grade. The chief complaints begin with the conflict of interest in the issuer-pays model, including rating shopping. Others are slowness and procyclicality, with ratings lagging markets then cliff-edge downgrades, and overreliance by regulators and mandates on ratings. The last are weak performance on structured products in 2007 to 2009, and limited transparency and competition among a few agencies.
A practice question
Which is the most commonly cited criticism of the issuer-pays model used by the major rating agencies?
- It lets agencies publish ratings before any analysis is complete.Why not: Not the standard criticism; the issuer-pays complaint concerns incentives, not the speed of publication.
- It creates a conflict of interest, since the rated entity pays and may press for a favourable rating. - correct
- It prevents agencies from rating sovereigns, which do not pay fees, so sovereign ratings are unreliable.Why not: Agencies rate sovereigns, often without being paid by them, so this is incorrect.
- It gives investors early exclusive access to ratings, which biases the ratings against issuers.Why not: Describes an investor-pays arrangement, confusing it with the issuer-pays model.
Under issuer-pays, the issuer's payment creates an incentive to be generous and enables rating shopping. This is the leading criticism.
A harder one
An industrial company has an issuer rating of BBB. Its senior unsecured bond is rated BBB and its junior subordinated bond is rated BB+. What best explains the lower rating on the subordinated bond?
- The issuer is more likely to default on the subordinated bond, since it can choose which of its bonds to pay first.Why not: Default is generally a firm-level event, with cross-default provisions; the difference lies in loss given default.
- Subordinated bonds always have longer maturities than senior bonds, and longer maturity means higher risk.Why not: Maturity is not the reason for notching; issue ratings are adjusted mainly for ranking and recovery.
- Issue ratings reflect expected loss: subordinated debt has lower priority and lower recovery, so it is notched down. - correct
- Issue ratings follow market yields, so the higher-yielding bond is given the lower grade by the agency.Why not: Ratings are assigned from credit analysis, not mechanically from yields.
Issue ratings start from the issuer rating and notch for seniority and security. Lower priority means lower recovery in default and hence a lower issue rating.
The hardest tier
An investment fund's mandate allows only investment-grade holdings. A bond is downgraded from BBB- to BB+. Many holders must sell on the same day, and the spread widens far more than the change in the issuer's fundamentals can justify. Which criticism of ratings does this best illustrate?
- Rating shopping by issuers.Why not: Concerns the choice of agency by issuers, not the effect of a downgrade on holders.
- Cliff effects from rules keyed to ratings, which make downgrades self-reinforcing. - correct
- Excessive granularity of the rating scale, which exaggerates small differences between issuers.Why not: The problem here is a threshold at the investment-grade boundary, not the number of notches.
- Lack of transparency in rating methodologies.Why not: A different criticism; the scenario concerns forced selling triggered by a threshold, not opacity.
Rules keyed to ratings, such as investment-grade-only mandates, force selling at a downgrade across the boundary. This creates cliff effects and amplifies the move beyond what fundamentals justify.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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