Why do companies pay rating agencies such as Moody’s and S&P to rate the bonds they are selling?Companies pay rating agencies such as Moody’s and S&P to rate their bonds, and the costs...
Why do companies pay rating agencies such as Moody’s and S&P to rate the bonds they are selling?
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?
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.
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.