The ratings assigned by rating agencies to the bonds of non-central government issuers have a major impact on the rate premium that they are obliged to pay above the benchmark risk-free rates.
The rating agencies collect and analyse all available accounting and other financial subjective and objective information in order to arrive at a rating that reflects the issuer’s ability to pay the interest and repay the principal of the debt. Another way of putting this is that they endeavour to arrive at a probability of default. They make use of complex financial ratio analyses, industry analyses and economic analyses.
The financial ratios used are many, including profitability, leverage, coverage, and liquidity ratios. The three principal agencies are Moody’s, Standard & Poor’s (S&P) and Fitch IBCA. The rating categories of the first two agencies, as well as brief explanations of selected categories, are shown in Table.