Don’t Take It at Face Value: What Investors Need to Know About Credit Rating Agencies

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With markets already rattled by elevated oil prices and a Federal Reserve that’s stuck in neutral, investors are understandably on edge about risk. In moments like these, there’s a tendency to reach for something that feels definitive, like a neat letter grade from a reputable institution that tells you, with apparent authority, that this bond is “safe,” or that one is “risky.”

Enter the credit rating agencies.

We’re not talking about consumer credit bureaus like Equifax, Experian, or TransUnion. We’re talking about the firms that grade the debt markets themselves.

The names Moody’s, S&P Global, Fitch Ratings may sound familiar to you. Together, they are the so-called “Big Three” that control nearly 95% of the global credit ratings market.

From AAA at the top, down to the dreaded triple-C, these agencies’ letter grades are baked into investment mandates, regulatory requirements, and the decision-making of institutional investors the world over.

But how much trust should investors really put into those letters?

Perhaps less than how much the market currently does, according to Dan Ivascyn, Chief Investment Officer of PIMCO, one of the world’s largest bond funds. Speaking on Bloomberg’s Odd Lots podcast in December 2025, Ivascyn warned that it was “very, very dangerous to assume something has an investment-grade rating just because the rating agencies assign a rating to it.”

He argued that investors have been lulled into a false sense of security by inflated credit ratings, at precisely the moment when risk is quietly migrating to the opaque world of private credit.

The warning signs are worth paying attention to.

Rating the Hand that Feeds You

Criticism about credit rating agencies is hardly new. The central problem boils down to a conflict of interest that stems from the “issuer-pays” model, which has been the dominant business model for the Big Three since the 1970s. Bond issuers (corporations, governments, or banks) pay the agencies to rate their debt, and those ratings are then made available to investors at no cost.

In simple terms, the entity being evaluated is also the one writing the check.

The agencies have long argued that this doesn’t compromise their independence. Ratings decisions are made by committee, not by individual analysts, and employees aren’t compensated based on the ratings they assign.

But the incentive structure is also baked in at a far more fundamental level. If an agency develops a reputation for tough ratings, issuers have every reason to “shop” around for a more favorable assessment.

This exact issue has been dramatized here in The Big Short, featuring an (ironically) vision-impaired S&P employee.

A History Lesson Worth Revisiting

Good cinema, but it’s grounded in fact. This conflict of interest has played out several times over the past few decades.

The first major warning shots came when Enron and WorldCom, two of the largest corporate bankruptcies in American history, were rated investment grade by the agencies right up until the moment they collapsed.

These failures triggered the first serious congressional push to regulate ratings agencies, eventually producing the Credit Rating Agency Reform Act of 2006, which established formal SEC oversight and a registration program for NRSROs.

But the reforms proved insufficient. Fast-forward a few years, and the Big Three were at the center of one of the most consequential failures in financial history during the Global Financial Crisis. Their provision of investment-grade ratings for structured finance securities was a critical part of how the subprime mortgage machine was assembled.

Private mortgage-backed securities issuance ballooned from $126 billion in 2000 to $1.145 trillion in 2006– and the agencies’ AAA stamps were the engine that made it all possible.

Rating agencies had assigned top-tier ratings to huge volumes of mortgage-backed securities, only to dramatically downgrade them when the housing market collapsed. Moody’s, for example, downgraded 83% of the $869 billion in mortgage securities it had rated AAA in 2006, all within a single year.

With numbers like these, it’s hardly far-fetched to think that the agencies were sacrificing quality ratings just to win a bigger share of the lucrative sector. Their revenue figures would certainly back this up. In 2008, the New York Times reported that structured finance ratings accounted for 53% of Moody’s total revenue by the first quarter of 2007.

The financial incentive to keep those ratings flowing, regardless of the underlying risk, was staggering. On top of that, structured finance issuers were actively shopping for agencies offering more favorable ratings.

A legal and regulatory reckoning did follow. The Dodd-Frank Act of 2010 imposed new disclosure requirements, required ratings analysts to pass qualifying exams, and notably stripped the agencies of certain legal protections they had previously enjoyed. S&P ultimately paid $1.37 billion in settlement, while Moody’s came under Justice Department investigation.

Have the Rating Agencies Learned Their Lesson?

Some signs point to yes.

A 2023 Harvard Business School study found that rating agencies were acting more defensively when evaluating higher-risk debt, a shift that appears to be driven by the agencies’ own self-interest. After all, a high-profile failure damages their credibility and, by extension, their business. The study found that missed defaults (where an agency either predicts a default that doesn’t happen or fails to predict one that does) had been slashed by 57%-72% compared to the pre-GFC period.

It’s progress, though not exactly the kind you’d frame and hang on the wall.

But neither the “issuer-pays” model nor the Big Three’s market dominance was ultimately disrupted.

And there are signs that the problems haven’t completely gone away. In its 2024 annual review of nationally recognized statistical rating organizations (or NRSROs), the SEC flagged, among many things, nine instances of failures to address or manage conflicts of interest.

And even if the major rating agencies have become more cautious, the underlying problems haven’t been resolved so much as they’ve migrated to a different corner of the market.

In recent years, the private credit market has seen rapid expansion, bringing risks in less transparent parts of the financial system. This has coincided with the rise of a new set of smaller rating agencies operating outside traditional bond markets.

According to the Financial Times, this shift is raising concerns that issuers in private credit markets can once again “shop” for more favorable ratings among agencies.

Just like in the lead-up to the Global Financial Crisis, these ratings appear, in some cases, more generous than the underlying risk would justify, raising questions about whether investors are being given an overly optimistic picture of credit quality. And unlike the post-crisis scrutiny applied to the Big Three, much of this activity is taking place among smaller firms where oversight is still evolving.

Already, regulators are paying attention. Back in November 2025, Bloomberg reported that the SEC had begun probing Egan-Jones, one of the most active rating firms in the private credit market, to examine whether commercial considerations had improperly influenced its ratings process. Time will tell whether this proves to be an early warning sign for something more systemic.

What’s clear, however, is that while credit activity shifts into private markets, the incentive structure that once drove rating inflation is far from gone– it’s simply re-emerged with different players.

Take Your Ratings with a Grain of Salt

None of this means investors should abandon credit ratings entirely.

For all their flaws, they still offer a useful tool for investors. As Marty Fridson, a past governor of the CFA Institute and consultant to the Federal Reserve Board of Governors, puts it: “In the end, it would scarcely be possible to quantify useful risk-reward relationships in the debt market were it not for the letter grades supplied by the much-maligned credit rating agencies.”

We made a similar point in an earlier commentary on stock market forecasters, Reading Tea Leaves: How Much Should You Trust Stock Market Forecasters? Our key takeaway here wasn’t that forecasts are useless, but that they should be treated as one data point among many, rather than as authoritative guidance.

The same logic applies here. Credit ratings provide a common language for assessing risk across a vast fixed-income universe. Without them, comparisons would be far more difficult.

The real danger comes when investors over-rely on ratings and use them as a substitute for analysis.

A 2023 paper published by Stanford researchers found that retail bond investors tend to rely heavily on credit ratings as a shortcut for assessing risk, often to their detriment. Investors commonly screen bonds by rating and then chase higher yields within those categories, effectively buying into deteriorating credits ahead of downgrades and defaults. Credit ratings tend to lag underlying fundamentals, which means that this approach can lead investors to systematically trade in the wrong direction.

The takeaway isn’t complicated: treat ratings as a starting point, not a verdict.

The subprime crisis wasn’t driven solely by what the agencies got wrong. It was also driven by investors who relied on ratings without doing their own homework.

Ratings offer a starting point. They were never meant to be the finish line.