06292017Headline:

What Is a Rating Agency?

Rating agencies play a vital role in the financial markets and can impact the value of investments. Understanding what rating agencies are and how they work is essential if you plan on becoming a successful investor.

Rating agencies play a very important role in the financial markets and can impact the value of many different types of investments on a regular basis. These agencies are supposedly unbiased and not affiliated with any particular investment or company.

What Rating Agencies Do

Rating Agency Cartoon

Rating Agency Cartoon

Rating agencies are independent companies that closely examined financial instruments and issue ratings based on their findings. The ratings that they issue give investors a starting point for determining the risk associated with a particular investment. For example, rating agencies issue ratings on mutual funds and bonds so that investors can gauge how much risk they are actually taking on when investing in a security.

Rating Agencies

Some of the most well-known rating agencies in the industry are Standard & Poor’s, Fitch and Moody’s. Their ratings are featured in many different financial publications such as the Wall Street Journal and Morningstar. If you’re thinking about investing in any mutual fund or bond, you should be able to find a rating for it from one of the three main credit rating agencies.

Considerations

Although the rating agencies do issue ratings on most of the popular investments, you should not take what they say as 100 percent truth. These agencies have been wrong many times before and they will inevitably be wrong again in the future. For example, before the 2008 financial crisis, they played a role in the problem by issuing strong ratings to mortgage-backed securities that held toxic mortgages. They also had the highest rating possible on Lehman Brothers just hours before it went bankrupt during the crisis. With these facts in mind, you should take any rating that they issue with a grain of salt. Their ratings are only opinions and do not necessarily tell you how safe an investment is in the market.

These ratings can also have an impact on returns. For example, bonds that are rated highly pay lower amounts of interest because they are viewed as safer investments. Other bonds with lower ratings have to pay higher interest rates to attract investors.