Therefore, in order to determine whether a bond is at a fair price and interest rate, an investor needs to know how risky the company or government offering the bond is. Finding this out is usually a difficult task that involves examining financial statements, listening to company leaders, making market forecasts, and then developing a model that takes in all of this information and spits out a single risk measure. Wouldn't it be nice if there were companies that did this and published the results?
This is where the ratings agencies come in. In the United States, Standard & Poor's, Moody's, and Fitch Ratings have an overwhelming market share for this sort of business, so they are seen as the go-to companies for bond risk analysis. As a result, the scores handed out by these agencies can carry a lot of weight in financial markets, and bonds with higher ratings tend to have higher prices and lower interest rates while bonds with lower ratings tend to have lower prices and higher interest rates. This relationship holds both because of perceived risk and also because some investors are required to only hold bonds that meet a minimum ratings threshold, which somewhat artificially decreases demand for lower-rated bonds.
The output published by the ratings agencies is an alphabetical score, roughly ranging from AAA or Aaa at the top (least risky) to D (already in default). You can see the specifics of the grades given by each of the ratings agencies here. Bonds that meet a minimum rating threshold (somewhere in the B range for each agency) are referred to as "investment grade," and bonds that don't meet this threshold are referred to as "junk bonds."
In theory, this system should work well, since it's more efficient to have a few firms performing due diligence on bond risk than it is to have each potential investor duplicating the same effort. However, the objectivity and/or competence of the ratings agencies frequently gets called into question. One reason for this is that, rather than getting paid by investors who use the ratings information, ratings agencies often get paid by the companies whose bonds they are rating. Another reason is that the ratings produced by the companies' models don't always turn out to correspond to the actual risk of the underlying bonds. One notable example of this was when mortgage-backed securities that were rated AAA by one or more of the agencies turned out to have a very high default rate.
Controversy surrounding the ratings agencies resurfaced when Standard & Poor's decided to downgrade bonds issued by the U.S. Federal Government from AAA (the highest rating) to AA+ (the second highest rating). The company published the assumptions behind its model, and the United States Treasury found that the company had made math errors in its analysis.
