Companies pay rating agencies such as Moody’s and S&P to rate their bonds, and the costs can be substantial. However, companies are not required to have their bonds rated; doing so is strictly voluntary. Why do you think they do it?  

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Companies pay rating agencies to rate their bonds because it increases their chances of getting investment funds. Here is how it works.

Imagine a scenario where you need a loan from the bank for investment purposes. The first thing that your bank will look at before giving you money is...

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Companies pay rating agencies to rate their bonds because it increases their chances of getting investment funds. Here is how it works.

Imagine a scenario where you need a loan from the bank for investment purposes. The first thing that your bank will look at before giving you money is your credit score. Your ratings are usually updated according to your borrowing history. If you are always on time with your loan repayments, your credit rating will be high. The bank may also look at your account activity. If the account has been active, it increases your chances of getting a loan. The bank may also want copies of your utilities bill and employment records. I am sure you have noticed that the bank needs a lot of information before they can give you a loan.

Companies also need loans to expand. These firms need millions to carry out their expansion projects. To borrow that kind of money, companies also need to reassure the lenders that they can repay their loans. Unlike individuals, companies cannot give out all their information to the public. They have to keep their trading secrets intact so that they can remain competitive.

That’s where credit rating agencies come in. Companies are willing to share some of their private information to these agencies for rating purposes. Based on their analysis, the rating agency rates the company’s bond as either investment or non-investment grade. Three rating agencies are recognized and acknowledged worldwide: Fitch, S&P, and Moody’s. If the company’s bond is rated investment grade by any of the above rating agencies, it gets investors because people believe the firm can repay the bond and honor interest payments.

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Bonds are fixed income instruments that are issued by companies or governments in need of funds. When a bond is issued, the seller declares the repayment schedule and specifies the interest and principal repayment amounts. Bonds can be held by buyers for their entire tenure or sold in the bond market at the prevailing rates.

Rating agencies like Moody's and S&P provide a rating to bonds based on current assets and liabilities of the issuer and how this could change over the tenure of the bond. Bond buyers are willing to accept the relatively low rate of returns offered, as the accompanying risk is also low. Companies issuing bonds pay rating agencies to rate the bonds, as evaluating the risk involved in buying the bonds requires a substantial amount of information, time, and effort. Most buyers are not in a position to do this themselves. They would rather rely on the experience of rating agencies. Getting a bond rated also allows the seller to adjust the rate of return based on the risk profile determined by the rating agency.

Buyers of bonds evaluate the risk of default from the rating given to the bonds. This is the reason why bond sellers are willing to pay rating agencies, though this is not required and is voluntary. A seller not willing to do that won't be able to find many willing buyers of their bonds.

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Companies, such as Moody's and S&P, pay rating agencies to rate their bonds because the bond-rating provides important information to potential buyers. A person who is considering investing in a bond will want to know the risk involved in that investment. The safest bonds are rated AAA, while the riskiest bonds will have a rating of CCC or lower. Depending on the rating agency, any bond in the A or B range is considered a safe investment. When a consumer decides to buy a bond with significant risk, that investor will expect a higher rate of return. Some investors have a very low tolerance for significant risk and will want to buy a bond that is safer and more likely to be redeemed. Other investors are willing to take chances when they invest, because they can make a significant profit if a risky investment pans out. Without a bond rating, it would be more difficult, but not impossible, for an investor to determine the risk involved in purchasing that bond.

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Because having a higher rating assigned to the bonds they are offering makes them much easier to sell.  The whole purpose of a company issuing bonds is to raise capital for expansions, remodeling, factory upgrades, etc., so they want to be able to sell the bonds in a reasonable amount of time, and those investors who buy large amounts of bonds typically only do so with those that are low risk.

The problem with companies paying rating agencies to rate their bonds is that there is a disincentive for those agencies to rate accurately.  This started back in the 1970s, and since their income is partially based on how many companies come to them for such ratings, then there is pressure to rate bonds more highly than they deserve.  This is, in part, what led to the huge sub-prime mortgage crisis in the United States, a prime cause of the current recession.

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