When a government or a company borrows money by issuing a bond there is a risk that they will not be able to repay the bond. If they miss a single coupon payment they trigger an event called default. Ratings agencies grew out of the local government bond market in the US in the 1800s where there were many debt crises as states issued too much debt, often to build railroads, and then defaulted on that debt. By looking at a borrower’s net income, debt level and assets the ratings agencies classify the quality of their debt according to their ability to repay.
Debt which is less likely to be repaid will compensate investors by offering a higher income, and as a result the rating received by a company or a country directly affects its cost of borrowing. The largest ratings agencies are Moody’s, Standard and Poors and Fitch. The entity issuing a bond pays to have its debt rated, which can lead to a conflict of interest as the agencies may compete to provide the highest rating. The rating is a letter code, as shown below. Ratings are dynamic, and as the financial wellbeing of a company or country wax and wane the rating will change to reflect their ability to repay their debt.