An issuer has paid every coupon on its bonds in full, but each payment arrived several weeks after its due date. Is that record relevant to what the issuer's credit rating assesses?

No, since a rating looks only at whether principal will be repaid at maturity, the timing of interest being a matter for the trustee

Yes, since a rating assesses the likelihood that the issuer will meet its financial commitments both in full and on time

No, since late but complete payment is a question of the issuer's cash management, which a rating does not take into account

Yes, though only once the delay has led the trustee to declare an event of default; before that, late but complete payment lies outside what a rating assesses

When the SEC first adopted the Nationally Recognised Statistical Rating Organisation designation in 1975, what regulatory need was it meeting?

Issuers were shopping among many small agencies for the best rating, and the SEC needed to limit which agencies an issuer could pay to rate its debt

Investors could not compare the agencies' different symbols, and the SEC needed one common notation that every recognised agency would have to adopt

The net capital rule applied different haircuts to debt of different credit quality, and the SEC needed an authoritative standard for what counted as investment grade

Exchanges required every listed bond to carry a rating, and the SEC needed to name the agencies whose ratings would satisfy those listing standards

Moody's, Standard and Poor's and Fitch were the first agencies recognised as NRSROs. On what basis were they recognised?

On their established market presence and the widespread use of their ratings by investors when the SEC first recognised them

On an SEC audit of the accuracy of the ratings they had published, which found their past ratings the most reliable

On a vote of the national securities exchanges, whose listing standards already relied on the three firms' ratings

On the length of their published track record, any agency with ten years of ratings behind it qualifying at the time

An insurer's investment guidelines require every bond it buys to carry a rating from an SEC-registered NRSRO. A private placement it is weighing is rated only by Kroll Bond Rating Agency. Does the bond meet the guideline?

Yes, since an insurer may treat any agency's rating as an NRSRO rating once its own credit staff have reviewed it and recorded their approval

Yes, since Kroll is one of the firms registered with the SEC as NRSROs, a group that reaches beyond Moody's, S&P and Fitch

No, since NRSRO status passes only to agencies that control a set share of the global ratings market, a threshold Kroll does not reach

No, since NRSRO registration is held by Moody's, S&P and Fitch alone, the three agencies that dominate the industry

A research note describes a corporate bond as rated Aaa2 by Moody's. Why can that not be a rating on Moody's long-term scale?

Moody's writes its top category as AAA in capitals, so a rating spelled Aaa must come from a different agency's scale

Moody's applies its numeric modifiers only from Baa downward, the categories above Baa being too narrow to be subdivided

Moody's attaches its 1, 2 and 3 modifiers only to the categories from Aa through Caa, so its top category Aaa carries no modifier

Moody's uses the numeral 2 only on its short-term scale, so a long-term rating can carry a 1 or a 3 but never a 2

A bond rated BBB plus by Standard and Poor's is downgraded by two notches. Where does it then stand on S&P's long-term scale?

At BB plus, the highest speculative grade rating, the second notch having taken it out of BBB

At BB, the middle of the BB category, each notch on S&P's scale being a whole letter category

At BBB, the middle of the category, still one notch above the lowest investment grade rating

At BBB minus, the lowest subcategory of the BBB category and still an investment grade rating

Two bonds carry Moody's ratings of Caa1 and Caa3. How do the two ratings compare?

Both sit in the Caa category, Caa1 at the higher end of it and Caa3 at the lower end

Both sit in the Caa category, Caa3 at the higher end of it, since a larger numeral marks stronger credit

They sit in different categories, Caa3 being the label Moody's gives an obligation already in default

They rank equally, the numerals separating the two bonds by maturity band within Caa rather than by credit quality

On the long-term scale used by Standard and Poor's and Fitch, which symbol marks an obligation on which the issuer has defaulted?

CCC minus, the lowest modified category on the scale

D, which sits below C at the foot of the scale

CC, the category assigned once any scheduled payment has been missed

C, the lowest category, there being no separate symbol for default

An issuer has senior secured bonds and subordinated notes outstanding, and an agency judges the issuer equally likely to miss a payment on either. Why might it still rate the subordinated notes lower?

Subordinated noteholders hold no vote on acceleration after a default, and a rating measures the strength of the holders' contractual voting rights

Agency convention fixes subordinated notes a full category below the issuer's senior rating, whatever recovery is expected on them in a default

Their junior place in the capital structure means less would be recovered in a default, so expected loss is higher at the same default probability

Subordinated notes carry no collateral, so the agency cannot place them on its scale at all and assigns them the issuer's lowest grade by default

A long-dated bond rated AAA loses a fifth of its market value when interest rates rise sharply, while the issuer remains exactly as creditworthy as before. Does the loss show that the rating was wrong?

Yes, since an AAA rating is meant to hold a bond's market price near par, so a fall of a fifth means the rating failed

No, since the agency will reflect the price fall at its next annual review, the point at which ratings catch up with prices

Yes, since the agency should have cut the rating as rates rose, an AAA grade covering every source of loss to the holder

No, since a rating measures credit risk rather than interest rate or market risk, and the issuer's credit has not changed

An agency's methodology estimates an issuer's probability of default. What must that estimate be tied to before it has a definite meaning?

A defined time horizon, over which the chance of a missed scheduled payment is measured

A stated recovery rate, without which a probability of default cannot be expressed

The bond's current market price, from which the probability is backed out afresh each trading day

The size of each holder's position, the probability varying with the amount held

A registered representative tells a retired client that an AAA-rated bond must be right for her because the agency has already vetted it. What is wrong with relying on the rating that way?

The rating is advice, but advice addressed to institutional buyers alone, so it may not be passed on to retail clients

A rating is a professional opinion that does not constitute investment advice, so it cannot settle whether this bond fits her

Nothing is wrong, since an AAA rating is the agency's recommendation to buy the bond, which the representative may adopt as his own advice

Nothing is wrong, since an NRSRO's rating carries a finding that the bond is suitable for retail investors seeking income

Before an agency publishes a newly determined rating, it notifies the issuer of the proposed rating. What may the issuer do at that point?

Require the agency to hand the rating to a different analytical team, chosen from a list of analysts the issuer approves

Negotiate the outcome within one notch, the proposed rating being treated as the agency's opening position in the talks

Supply additional factual information for the agency to take into account, though it may not negotiate the rating itself

Refer the rating to the exchange that lists its bonds, which may delay publication until it has reviewed the analysis

Analysts rating a corporate issuer calculate its debt to EBITDA and its interest coverage. How does the rating process turn those ratios into evidence about the appropriate rating?

By comparing them with fixed cut-offs for each rating category that the SEC publishes for every registered agency

By converting them into a market-implied spread, the rating being whichever category trades at that spread today

By comparing them with the issuer's own ratios in the year it was first rated, any deterioration lowering the rating

By benchmarking them against the distribution of the same ratios observed across issuers that hold each rating

An issuer announces a large debt-financed acquisition, and an agency signals that it may cut the issuer's rating once it has assessed the deal. How does placing the issuer on negative CreditWatch differ from assigning it a negative outlook?

CreditWatch flags a specific event that makes a change possible in the near term; an outlook gives the likely direction over the medium term

CreditWatch gives the likely direction over the next twelve to twenty-four months; an outlook flags a specific event that may move it within weeks

CreditWatch means a downgrade has been decided and awaits publication; an outlook means the agency has opened a formal review of the rating

CreditWatch is opened only at the issuer's own request; an outlook is the agency's unprompted view, the two looking the same distance ahead

The analytical team assigned to an issuer completes its quantitative and qualitative work and proposes a rating. Who makes the final determination, and how?

All of the agency's analysts together, each casting one vote, with a two-thirds majority needed to assign it

A rating committee, which receives the analysts' findings and proposed rating and decides by majority vote

The agency's chief credit officer, who adopts or rejects the team's proposal alone without any vote being held

The lead analyst, whose proposal becomes the rating once a senior colleague in the team has signed it off

After the 2008 crisis exposed the conflicts in the issuer-paid model, did the Dodd-Frank Act end that model for the major rating agencies?

Yes; it required the SEC to assign each rating to an agency by rotation, so that issuers no longer choose which agency they pay

Yes; it required the investors who rely on a rating to pay for it, ending the fees paid by the issuers whose debt is being rated

No; it required the SEC to study the feasibility of alternative compensation models, alongside new conflict disclosure rules and prohibited practices

No; it capped the fee an issuer may pay for a rating at a level the SEC sets for each class of security the agencies rate

Before the 2008 crisis the major agencies assigned AAA ratings to thousands of structured securities backed by subprime mortgage loans. What did an SEC examination later find about how those ratings had been issued?

That the arrangers had given the agencies falsified loan files, leaving them no means of detecting that underwriting had slipped

That the agencies had cut the ratings promptly once defaults rose, but most investors had ignored the downgrades as they came

That the agencies' models had used too little historical data, but no agency had been aware of any weakness in the loans

That the agencies had been aware of deteriorating underwriting standards on the loans while they continued to issue their highest ratings

The SEC's Office of Credit Ratings examines NRSROs. Where conflicts of interest are concerned, what do those examinations specifically look for?

Evidence that commercial pressures are influencing the rating outcomes the organisation produces

Evidence that the organisation's ratings differ from the spreads at which the rated bonds trade

Evidence that the organisation's fees fall short of what it costs to produce each of its ratings

Evidence that the organisation's analysts lack the qualifications the SEC sets for each class

Since the SEC's 2015 amendments to Rule 2a-7 took effect, a money market fund's board is assessing a commercial paper issue that carries an A-1 rating. What part may that rating play in the board's decision?

A contributory one: the board may weigh it, provided the rating is kept out of the fund's regulatory filings to avoid reliance

A contributory one: the board may weigh it in its own credit analysis, and must disclose on Form N-MFP any rating it considered

A decisive one: the board must treat an A-1 rating as conclusive within its analysis, overriding any other factor that it weighs

None: the amendments bar a board from taking any agency rating into account when it decides whether the fund may buy a security

A bank calculates its capital requirement for a corporate bond it holds using the Basel framework's standardised approach. How is the risk weight for that exposure set?

By the volatility of the bond's market price over the prior year of daily trading data

By the bank's own model of the issuer's default probability, which the approach requires

By reference to the external credit rating that the exposure carries from a rating agency

By a single weight applied to every corporate exposure, whatever the borrower's credit

State investment rules confine many pension funds and insurers to investment grade holdings. Two bonds of otherwise similar issuers sit one notch apart, at Baa3 and Ba1 from Moody's, and the yield gap between them is far wider than the gap between Baa1 and Baa3 bonds. What do those rules suggest explains the jump?

Federal law caps the coupon a Ba1 issuer may pay, so its bonds must trade at a discount to deliver the market yield to buyers

Ba1 bonds are left out of TRACE reporting, so dealers quote them without trade data and widen their spreads to cover the risk

Ba1 bonds are excluded from margin accounts by federal rule, so leveraged holders must sell them and so depress their price

The investment grade line splits the population of potential buyers sharply, so prices jump across it instead of moving smoothly

A money market fund's adviser, acting as the board's delegate, is deciding under Rule 2a-7 whether a commercial paper issuer's notes may be bought for the fund. Which matters must its credit analysis address?

The issuer's financial condition, its sources of liquidity, its ability to withstand adverse events and its position in its industry

The issuer's share price performance, its dividend record, the analyst coverage of its stock and its stock's index membership

The notes' secondary market turnover, the dealers' quotes for them, their settlement history and their use as repo collateral

The fund's own redemption forecasts, its weekly liquid assets, the mix of its shareholders and the remaining maturity of the notes themselves

Two commercial paper issuers are rated Prime-2 and Prime-3 by Moody's. How does their access to money market fund investors typically compare today?

The Prime-3 issuer reaches the funds at a higher spread, while the Prime-2 issuer's paper is capped at three percent of each fund's assets

Both reach the funds on equal terms, since the funds' purchases do not turn on short-term ratings and they draw no line between the two

Neither can sell to the funds at all, since money market funds may buy paper only from issuers rated Prime-1 at the time of each purchase

A commercial paper issuer is rated Prime-2 by Moody's. Which Standard and Poor's short-term rating would place its paper in the same tier?

A-3, S&P's scale sitting one step below Moody's at each level

A-1, S&P's top category, which ranks level with Prime-2

A-2, the second of S&P's three short-term categories

BBB, the long-term category S&P pairs with Moody's tier two

Agencies normally cap a company's rating at the rating of the sovereign in whose country it operates. Which company is the likeliest to be rated above its sovereign?

A domestic utility with very low leverage whose revenues are earned in local currency from regulated tariffs

A large domestic retailer whose debt is held mostly by local pension funds and by local insurance companies

A state-owned bank whose deposits and bonds the government has guaranteed in full and without limit

An exporter earning significant foreign currency revenues and holding substantial assets outside the country's jurisdiction

Which one of the following enters a sovereign credit rating but does not apply to the analysis of a corporate issuer?

The government's taxing power and its fiscal flexibility

The return on invested capital it earns against its peers

The competitive position of its main lines of business

The depth and experience of its senior management team

A government that issues its own currency misses a payment on bonds denominated in that currency. How would a rating analyst characterise the default?

As a failure of ability to pay, since under every currency regime a government is barred by law from creating money to service its own debt

As a failure of willingness to pay, a political choice, since a government controlling its currency is always able in principle to print money for local-currency debt

As outside the sovereign rating altogether, since agencies assess only a government's foreign currency debt and set its local bonds aside

As a failure of ability to pay, the government's reserves of foreign exchange having fallen too low to meet the payment on the date it fell due

A credit rating agency applies to the SEC for registration as a Nationally Recognised Statistical Rating Organisation. What evidence that its ratings are relied on in the market must the application contain?

A statement of its subscriber numbers and subscription revenue in each of the three preceding years, reviewed and confirmed in writing by an independent public accountant

Written confirmations from issuers that have paid it for ratings, each stating that it has relied on those ratings in pricing its own debt offerings for at least three years

Written certifications from qualified institutional buyers unaffiliated with it, each stating that it has used the applicant's ratings for at least the three preceding years

Letters from national securities exchanges confirming that bonds listed with them have carried its ratings in their listing documents for at least the three preceding years

Two credit analysts at a registered rating organisation each take part in determining a rating. One directly owns notes issued by the industrial company she is rating; the other directly owns bonds of the national government whose sovereign rating he is helping to determine. How does Rule 17g-5's ownership prohibition apply?

It bars the government's rating but not the industrial company's, holdings of a national government's debt being the ownership the rule singles out

It bars both ratings, direct ownership by an analyst who takes part in a rating being prohibited whichever person or government is rated

It bars neither rating, the prohibition reaching securities owned by the organisation itself rather than those held by its individual analysts

It bars the industrial company's rating but not the government's, the prohibition excluding a sovereign nation and an agency of a sovereign nation

Credit Rating | Financial Regulation Courses

Understanding Credit Rating

A credit rating is a forward-looking opinion issued by a Nationally Recognised Statistical Rating Organisation on the relative creditworthiness of a debt issuer or a specific debt obligation, expressing the agency's assessment of the probability that the issuer will meet its financial commitments in full and on time. Credit ratings are the foundational credit risk classification system of global fixed income markets, determining which institutional investors may hold which securities, setting borrowing costs across the investment spectrum, and directly influencing the capital requirements imposed on financial institutions by banking regulators.

The Rating Agencies and Their NRSRO Status

Three rating agencies dominate the global credit rating industry: Moody's Investors Service, Standard and Poor's Global Ratings, and Fitch Ratings. Together they control approximately ninety-five percent of the global ratings business and are collectively known as the Big Three. In addition to the Big Three, as of March 2024 there are ten total firms registered with the SEC as Nationally Recognised Statistical Rating Organisations, including A.M. Best, Kroll Bond Rating Agency, and Morningstar Credit Ratings.

The NRSRO designation originated in 1975 when the SEC adopted it to identify rating agencies whose opinions would be accepted for purposes of applying the net capital rule to broker-dealers under SEC Rule 15c3-1 under the Securities Exchange Act of 1934. The net capital rule required broker-dealers to apply different haircuts to debt securities of different credit qualities, and the SEC needed an authoritative standard to determine what qualified as investment grade. Moody's, Standard and Poor's, and Fitch were the first three recognised, based on their established market presence and widespread use by investors.

The Credit Rating Agency Reform Act of 2006 formalised the NRSRO registration process, requiring agencies seeking NRSRO status to register with the SEC and comply with specific disclosure and conduct requirements. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 created the SEC's Office of Credit Ratings to oversee NRSROs, conduct regular examinations, and enforce compliance with SEC rules. The Office of Credit Ratings represents the most comprehensive direct regulatory supervision of rating agencies in United States history.

Registration by Category of Obligor

Registration as a Nationally Recognised Statistical Rating Organisation is not a single status that attaches to everything an agency rates. The Securities Exchange Act defines the organisation by reference to the categories of obligor for which it issues credit ratings certified by qualified institutional buyers — financial institutions, brokers or dealers; insurance companies; corporate issuers; issuers of asset-backed securities; and issuers of government securities, municipal securities or securities issued by a foreign government — and an applicant states in its application the categories for which it intends to apply. The SEC, by order, grants registration for ratings in the subject category or categories of obligors, and an organisation already registered that wishes to add a class of credit ratings must file an application to add that class on Form NRSRO, which is subject to the same review as an initial application.

The evidence that an applicant's ratings are used in the market comes from institutional investors. The application must include, on a confidential basis, written certifications from not fewer than ten qualified institutional buyers, none of them affiliated with the applicant, with at least two certifications for each category of obligor, and each certifying buyer must state that it has used the applicant's credit ratings for at least the three years immediately preceding the date of the certification in the category or categories concerned. No qualified institutional buyer is liable in any private right of action for any opinion or statement expressed in such a certification.

Within ninety days after an application is furnished, or within a longer period to which the applicant consents, the SEC must either grant registration by order or institute proceedings to determine whether registration should be denied. Registration is not an endorsement of the organisation's ratings: it is unlawful for an NRSRO to represent or imply in any manner whatsoever that it has been designated, sponsored, recommended or approved, or that its abilities or qualifications have in any respect been passed upon, by the United States or any agency, officer or employee of the United States.

The Rating Scales

Moody's and Standard and Poor's use parallel but distinct notation systems that candidates must know precisely.

Moody's long-term rating scale descends from Aaa — its highest rating, assigned to obligations of exceptional creditworthiness — through Aa, A, Baa, Ba, B, Caa, Ca, and C. Moody's appends numeric modifiers 1, 2, and 3 to each category from Aa through Caa, where 1 indicates the higher end of the category, 2 the middle, and 3 the lower end. Baa3 is therefore the lowest investment grade rating in the Moody's system.

Standard and Poor's and Fitch use an alphabetic scale with plus and minus modifiers. Their highest rating is AAA, descending through AA, A, BBB, BB, B, CCC, CC, C, and D for default. The plus and minus modifiers subdivide each major category, so BBB plus is the highest and BBB minus is the lowest subcategory within the BBB category. BBB minus is the lowest investment grade rating in the S&P and Fitch systems.

The investment grade threshold is Baa3 at Moody's and BBB minus at S&P and Fitch. This threshold is not merely a labelling convention. It is a regulatory and contractual boundary that determines which securities pension funds, insurance companies, bank trust departments, and money market funds may purchase. Many institutional mandates explicitly prohibit below-investment-grade holdings. When a bond falls below the threshold — a fallen angel — it is sold by institutions whose mandates prevent them from holding speculative grade paper regardless of the price, often creating significant selling pressure independent of any change in the bond's fundamental value.

What a Credit Rating Measures

A credit rating is a relative measure of default risk and expected loss severity. Moody's describes its ratings explicitly as forward-looking opinions of the relative credit risks of financial obligations. The rating does not measure liquidity risk, interest rate risk, market risk, or any risk other than credit risk. It does not guarantee the rated obligation will be repaid, and it does not constitute investment advice. It is a professional opinion, subject to revision as circumstances change.

Two related but distinct concepts underlie rating methodology. Probability of default is the likelihood the issuer will fail to make a scheduled payment within a defined time horizon. Loss given default is the expected proportion of principal and accrued interest that would not be recovered if a default occurred, reflecting the seniority of the obligation in the capital structure and the quality of any collateral. Combined, probability of default and loss given default determine expected loss, which is the metric most directly relevant to bond investors and the one that rating methodologies are ultimately designed to estimate.

The Rating Process

The rating process typically begins when an issuer engages a rating agency and provides detailed financial information — audited financial statements, management presentations, business plans, and often access to senior management. The rating agency assigns a team of analysts who conduct quantitative analysis of the issuer's financial metrics and qualitative assessment of its business position, competitive environment, management quality, and industry dynamics.

For corporate ratings, analysts examine key financial ratios including debt to EBITDA, interest coverage, free cash flow generation, and return on invested capital, benchmarking these against the distribution observed across similarly rated issuers. The qualitative assessment addresses the competitive position of the business, the stability and predictability of cash flows, the depth and experience of management, and governance practices. The analysts present their findings and a proposed rating to a rating committee, which makes the final determination by majority vote. The issuer is notified of the proposed rating before it is published, allowing the issuer to provide additional factual information, though not to negotiate the rating outcome.

Ratings are then monitored continuously. Rating agencies place issuers on Watchlist or CreditWatch — positive or negative — when a specific event or development makes a rating change possible in the near term. A negative Watchlist indicates the agency is reviewing for a potential downgrade, while a positive Watchlist indicates potential upgrade. Outlook assignments — stable, positive, negative, or developing — indicate the likely direction of the rating over the medium term, typically twelve to twenty-four months.

Issuer-Paid Model and Conflicts of Interest

The dominant business model of the major rating agencies is the issuer-paid model: the company whose debt is being rated pays the rating agency for the rating. This creates a structural conflict of interest that has been extensively documented, most acutely in the period preceding the 2008 financial crisis. Rating agencies assigned AAA ratings to thousands of structured finance securities backed by subprime mortgage loans, earning large fees from the issuers and arrangers of those securities. When the underlying mortgage loans defaulted in large numbers, those AAA ratings proved catastrophically inaccurate, and a Securities and Exchange Commission examination found that rating agencies had been aware of deteriorating underwriting standards while continuing to issue their highest ratings.

The Credit Rating Agency Reform Act of 2006 and the Dodd-Frank Act imposed new conflict-of-interest disclosure requirements and prohibited certain practices that could compromise rating integrity. The SEC's Office of Credit Ratings examines NRSROs specifically for evidence that commercial pressures are influencing rating outcomes. The Dodd-Frank Act also required the SEC to study the feasibility of alternative compensation models and mandated periodic review of how credit ratings are used in federal regulations.

Subscriber-Paid Ratings and Prohibited Conflicts

Changing who pays for a rating changes the conflict rather than removing it. Rule 17g-5 under the Exchange Act identifies as conflicts of interest being paid by persons for subscriptions to receive or access an NRSRO's credit ratings where those persons may use the ratings to comply with, and obtain benefits or relief under, statutes and regulations using the term NRSRO, and being paid by subscribers who also may own investments or have entered into transactions that could be favourably or adversely affected by a credit rating the organisation issues. An NRSRO may have such a conflict only if it has disclosed the type of conflict on Form NRSRO and maintains and enforces written policies and procedures to address and manage it.

Other conflicts are prohibited outright, whatever disclosure is made. An NRSRO may not issue or maintain a credit rating with respect to an obligor or security where the organisation, or a person associated with it, made recommendations to the obligor, or to the issuer, underwriter or sponsor of the security, about the corporate or legal structure, assets, liabilities or activities of the obligor or issuer.

Ownership is treated in the same way. An NRSRO may not issue or maintain a credit rating with respect to a person where the organisation, a credit analyst who participated in determining the rating, or a person responsible for approving it directly owns securities of, or has any other direct ownership interest in, the rated person, but that prohibition excludes a sovereign nation and an agency of a sovereign nation. It also may not issue or maintain a rating where an analyst who participated in determining or monitoring the rating, or a person responsible for approving it, received gifts, including entertainment, from the obligor or from the issuer, underwriter or sponsor of the rated securities, other than items provided in the context of normal business activities, such as meetings, with an aggregate value of no more than twenty-five dollars.

Ratings in Federal Regulation and Institutional Investment

Beyond their direct market function, credit ratings are embedded in federal regulation at multiple levels, though the Dodd-Frank Act directed federal agencies to reduce their regulatory reliance on NRSRO ratings and develop alternative standards of creditworthiness.

The SEC's net capital rule under Rule 15c3-1 continues to apply different haircuts to broker-dealer bond inventories based on credit quality, but it no longer uses rating-based criteria to determine the applicable haircut percentages. Until amendments that took effect on 7 July 2014, adopted to implement Section 939A of the Dodd-Frank Act, a nonconvertible bond qualified for the lower haircuts only if at least two NRSROs rated it in one of their four highest rating categories; the rule now grants them to a bond that the broker-dealer determines has only a minimal amount of credit risk, under written policies and procedures for assessing creditworthiness that it establishes, documents, maintains and enforces, and a firm that makes no such assessment must take the higher deductions. SEC Rule 2a-7 governing money market fund investments permits these funds to hold only securities meeting minimum quality standards, which until the SEC's 2015 amendments were defined in part by reference to NRSRO ratings. Those amendments, adopted in September 2015 to implement Section 939A of the Dodd-Frank Act and required from 14 October 2016, removed the rating references: a money market fund may now buy a security only if the fund's board, or its delegate, determines that it presents minimal credit risks, on an analysis of the issuer's financial condition, sources of liquidity, ability to withstand adverse events and industry position. A fund may still weigh ratings in that analysis, and must disclose on Form N-MFP any rating its board considered. Bank capital requirements under the Basel framework permit banks that use the standardised approach to calculate risk weights for credit exposures by reference to external credit ratings.

Pension funds and insurance companies are subject to state investment regulations that in many cases restrict portfolio holdings to investment grade securities, effectively making the Baa3 or BBB minus threshold a hard constraint on the investable universe for these large pools of capital. The practical consequence is that the investment grade boundary creates a sharp discontinuity in the population of potential buyers for any given security, producing significant price discontinuities at and near the threshold.

Short-Term Ratings

Rating agencies publish separate short-term rating scales for debt instruments with original maturities of one year or less, most importantly commercial paper. At Moody's, the highest short-term rating is Prime-1, followed by Prime-2 and Prime-3. At Standard and Poor's and Fitch, the highest is A-1, followed by A-2 and A-3. Prime-1 and A-1 issuers — referred to as tier-one issuers — have the widest access to money market funds, which SEC Rule 2a-7 restricts to high-quality instruments; until the 2015 amendments the rule drew that line by rating itself, admitting paper rated in the two highest short-term categories and capping second-tier holdings at three percent of assets. Prime-2 and A-2 issuers qualify as tier-two and face a somewhat smaller investor base and marginally higher spreads. In practice the minimal-credit-risk standard and the funds' own preferences keep money market funds concentrated in tier-one and tier-two paper, leaving issuers below tier-two with little or no access to the money market fund investor base.

Sovereign Credit Ratings

Rating agencies assign credit ratings to sovereign governments as well as corporate entities, assessing the ability and willingness of national governments to service their debt obligations. Sovereign ratings incorporate factors that do not apply to corporate analysis: the government's taxing power and fiscal flexibility, monetary policy capacity, currency regime, external debt burden, political stability, and institutional quality. The distinction between ability to pay and willingness to pay is particularly important in sovereign analysis — a government that controls its own currency can in principle always print money to service local-currency debt but may choose to default for political reasons, and a government borrowing in foreign currency faces genuine constraints on its ability to service obligations if foreign exchange reserves are insufficient.

Sovereign ratings act as a ceiling on the ratings of entities domiciled within the sovereign's jurisdiction, because a corporate issuer operating within a country faces the same country-specific risks — currency controls, nationalisation, systemic banking crises — that constrain sovereign creditworthiness. A corporation cannot in principle carry a higher credit rating than the sovereign of the country in which it operates, except in limited circumstances where the corporation has significant foreign currency revenues and assets outside the sovereign's jurisdiction.

Examination Relevance and Key Takeaways

Credit ratings are tested on the SIE, Series 7, and Series 65 examinations primarily in the context of the investment grade threshold, the specific rating scales of Moody's and Standard and Poor's, the role of NRSROs, and the impact of ratings on institutional investment eligibility and bond pricing.

The core points to retain are these: a credit rating is a forward-looking opinion of relative creditworthiness issued by a Nationally Recognised Statistical Rating Organisation registered with and regulated by the SEC; the Big Three NRSROs are Moody's, Standard and Poor's Global Ratings, and Fitch Ratings, controlling approximately ninety-five percent of the global market; the investment grade threshold is Baa3 at Moody's and BBB minus at Standard and Poor's and Fitch, with Moody's using numeric modifiers 1 through 3 and Standard and Poor's and Fitch using plus and minus to subdivide categories; securities rated below the investment grade threshold are speculative grade or high yield, also called junk bonds, and are excluded from the investable universe of many institutional investors whose mandates or regulatory requirements restrict them to investment grade holdings; a fallen angel is a bond downgraded from investment grade to below investment grade, triggering forced selling by investment grade constrained investors regardless of price; the NRSRO designation was created by the SEC in 1975 for purposes of the net capital rule under Rule 15c3-1, and the Credit Rating Agency Reform Act of 2006 formalised the registration process, with the Dodd-Frank Act creating the Office of Credit Ratings to conduct ongoing NRSRO examinations; the dominant issuer-paid business model creates structural conflicts of interest that were exposed acutely in the 2008 financial crisis when AAA ratings on subprime mortgage securities proved catastrophically inaccurate; and short-term ratings at Moody's use the Prime-1 through Prime-3 scale while Standard and Poor's and Fitch use A-1 through A-3, with tier-one issuers at Prime-1 or A-1 having the widest access to money market fund investors, although since the SEC's 2015 amendments Rule 2a-7 eligibility has turned on a fund's own determination that paper presents minimal credit risks rather than on its rating.