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Credit Ratings

The Rating Process

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The Rating Process

When a company issues a bond, the rating process unfolds in stages: initial analyst research, management meetings, internal committee review, and post-issuance monitoring. Each stage introduces delays and information constraints. Analysts work from quarterly financial statements and management guidance—data that is at minimum weeks old. Committee structures, while providing checks and balances, can also slow downgrades. Understanding how the process works and where it lags helps investors anticipate rating changes.

Key takeaways​

  • An initial rating typically takes 2–4 weeks from the issuer's request, involving analyst research, a management meeting, and committee approval.
  • Analysts gather quantitative metrics (leverage, coverage, margins) and qualitative information (competitive position, strategy, management quality) from financial statements and company meetings.
  • A rating committee (usually 3–5 senior analysts) reviews the analyst's recommendation and votes on the rating; disagreement can prompt revision or debate.
  • Once a bond is rated, the rating agency monitors it quarterly or annually, placing it on "watch" if changes in fundamentals signal a potential rating change.
  • Downgrades often lag negative news by weeks or months because agencies require multiple quarters of data or escalating concerns before moving.

The initial rating request​

When a company plans to issue bonds, it approaches rating agencies to request ratings. The typical process:

  1. The company's investment bank or CFO office contacts the rating agency's transaction team.
  2. The company selects which agencies to approach (typically all three Big Three to ensure broad market acceptance).
  3. The company submits initial information: business description, financial statements (usually the most recent quarter and year), debt structure, and use-of-proceeds.
  4. The rating agency assigns an analyst or small team.

The company must decide whether to seek ratings from one, two, or all three agencies. Seeking all three de-risks the offering (all three agree to rate it, likely improving pricing) but costs more in rating fees. Issuers targeting institutional investors typically seek all three; smaller or private placements might use one or two.

The analyst research phase​

An analyst assigned to a new rating request begins with 1–2 weeks of research:

  • Financial analysis: Build a multi-year model of the company's revenues, EBITDA, debt, and free cash flow. Calculate leverage (debt/EBITDA), interest coverage (EBITDA/interest), free cash flow/debt, and other metrics. Compare these to industry peers and historical benchmarks.
  • Qualitative assessment: Evaluate the company's market position, competitive moat, management team, growth prospects, and strategic risks.
  • Industry and macro analysis: Assess where the industry stands in its cycle, regulatory risks, commodity exposure, and macroeconomic sensitivity.
  • Debt structure review: Examine the specific bonds being issued—their seniority, covenants, maturity, call features—to determine issue-specific ratings.

The analyst gathers information from:

  • Company financial statements (10-K for public companies, private financials for private firms).
  • Investor presentations, earnings call transcripts, equity research reports.
  • Industry reports, regulatory filings, trade publications.
  • Prior rating agency reports on the company or sector.

The analyst then drafts a rating recommendation and rationale, typically a 10–30 page report.

The management meeting​

Before finalizing a rating, the analyst (often accompanied by a senior analyst or manager) meets with the company's CFO, investor relations, or treasury team. This meeting serves several purposes:

  • Data verification: The analyst confirms financial projections, business assumptions, and strategic direction.
  • Deep dives: Management explains significant changes (acquisition, divestiture, restructuring), near-term challenges, or opportunities.
  • Understanding of covenants and refinancing: Discussion of the debt structure, maturity schedule, and refinancing plans.
  • Management quality assessment: The analyst gauges management's financial discipline, transparency, and realistic outlook.

The management meeting is often the first time management learns the potential rating. A company hoping for A− but told the preliminary view is BBB+ can negotiate or provide additional information to move the needle. Some companies even withdraw their rating request if the preliminary indication is lower than expected (though this is rare and signals market skepticism).

The analyst updates the rating report post-meeting based on new information or clarifications.

The rating committee and vote​

The analyst's recommendation goes to a rating committee, typically consisting of:

  • The lead analyst.
  • A senior analyst or rating manager (chair).
  • An industry specialist (for large sectors).
  • A representative from the rating agency's governance/compliance team.

The committee reviews the analysis, discusses any disagreements, and votes on the rating. Votes are typically unanimous or near-unanimous; split votes are escalated or debated.

Committee meetings are brief (15–45 minutes for routine ratings, longer for complex or contentious cases). The chair ensures consistency with prior ratings, sector benchmarks, and the agency's rating philosophy.

Once the committee approves, the rating is released to the company (usually same day) and then published to the market (within a few hours to next business day, depending on agency and market protocols).

Post-issuance monitoring​

After a bond is issued and rated, the rating agency assigns a monitoring analyst (sometimes the same, sometimes a different analyst) to track the issuer's credit quality. Monitoring occurs:

  • Quarterly: Review of earnings, debt levels, and any news.
  • Annually: Deeper review, including a potential management meeting or conference call.
  • As-needed: If negative news emerges or the issuer is on a watch list.

The monitoring analyst may recommend no action (rating unchanged), a watch placement (potential upgrade or downgrade pending further information), or an outright rating change.

Watch lists and outlooks​

Between formal rating changes, rating agencies use intermediate signals:

  • Positive/Negative Watch: A formal notification that the rating is under review and likely to change (upgrade or downgrade) within 90 days. Watch placements are usually triggered by announced M&A, covenant violations, earnings misses, or management changes. Watch typically lasts 4–12 weeks; the agency then either removes the watch (rating unchanged) or executes the upgrade/downgrade.

  • Positive/Negative/Stable Outlook: A longer-term signal (1–2 year horizon) that the rating could move. A negative outlook suggests downgrade risk; a positive outlook, upgrade potential. Outlook is less dramatic than watch and does not require imminent action.

Watch placements are often market-moving. When a company is placed on negative watch, institutions that hold IG only may begin selling (before the downgrade, anticipating the forced sell later). The market prices in the watch before the actual downgrade.

Timeline from news to rating change​

A common pattern illustrates the lag:

  • Day 1: Company announces disappointing earnings or major adverse news (customer loss, lawsuit, acquisition failure).
  • Days 2–7: Market reprices the bond; yields widen, prices fall.
  • Week 2: If news is significant, the analyst likely places the bond on watch (or initiates one if not already watching).
  • Weeks 3–8: Analyst gathers more information, meets with management, refines assumptions.
  • Week 9: Rating committee votes; downgrade is released.
  • After downgrade: Index funds and policy-bound funds sell; prices fall further.

By the time the downgrade is official, much of the repricing may already be reflected in the market. However, mechanical selling post-downgrade (index fund forced sales, policy flush) usually drives a secondary price move.

Challenges and blind spots in the process​

The rating process has inherent lags and information asymmetries:

  1. Data freshness: Financial statements are at minimum 4–6 weeks old when filed; analyst research uses these aged figures. A company's situation can deteriorate rapidly between filings.

  2. Management credibility: Analysts rely on management guidance and projections. Management may be optimistic, delusional, or deliberately obscure bad news. The 2008 financial crisis exposed rating agencies' over-reliance on rosy management forecasts in mortgage origination.

  3. Sector forecasting: Agencies struggle to forecast sudden industry disruptions (coal declining faster than expected, e-commerce upending retail). A company rated A for 20 years based on stable industry fundamentals can face abrupt downgrade if the industry collapses.

  4. Gray-zone downgrades: For bonds between-the-lines (is this a downgrade or hold?), rating committees can delay or waffle. A company with deteriorating leverage but stable EBITDA might stay unchanged for a year, then face a surprise downgrade when leverage crosses a threshold.

  5. Reputational incentives: Agencies want to avoid surprise defaults (which look bad) and surprise upgrades (which look like flip-flopping). This creates a bias toward slow, gradual moves rather than sharp changes.

The role of equity analysts and CDS prices​

While rating agencies use their own proprietary analysis, they also pay attention to:

  • Equity analyst views: If sell-side equity analysts are downgrading earnings forecasts, it signals fundamental weakness. Credit analysts may lag equity analysts by weeks or months.
  • Credit default swap spreads: CDS prices (insurance against default) often lead credit ratings. If 5-year CDS spreads widen from 100 bps to 300 bps on news, the rating agency may accelerate a downgrade decision.
  • Bond market repricing: If a bond yield spikes from 4% to 6% in a week, the market is pricing in elevated default risk, often before the rating agency moves.

Sophisticated investors sometimes arbitrage these lags, buying bonds that the market has repriced below fundamental value but before rating downgrades force institutional selling.

Refinancing risk and watch placements​

One area where rating agencies are active is monitoring refinancing cliffs. If a large bond matures in 12–18 months and the issuer's credit quality is deteriorating, the agency may place the bond on watch because the refinancing risk is acute.

Example: A BBB company faces a $500M bond maturing in 18 months. If the company's leverage suddenly rises to 4.5x (from 3.5x) due to an acquisition, the agency might place the bonds on negative watch, flagging that refinancing of that maturity at a reasonable rate is now uncertain.

Flowchart​

Next​

The watch list and outlook signals that rating agencies publish between formal rating changes often contain important information for investors. The next article explores these intermediate signals and how to interpret them.