Standard & Poor’s (S&P), a subsidiary of McGraw-Hill Inc., is a leading U.S. financial services company. Standard & Poor’s is best known for its S&P 500 Index and its S&P bond-rating system. In 1860 Henry Poor published The History of Railroads and Canals in the United States, supplying financial information for investors, primarily Europeans, wanting to increase participation in the country’s infrastructure’s growth. Poor’s publications emphasized “the investor’s right to know.” The Standard Statistics Bureau was formed in 1906 and in 1916 began assigning ratings to corporate and sovereign debt. In 1941 Poor’s publishing operations merged with Standard Statistics to create Standard & Poor’s Corporation.
The S&P 500 Index is a broad-based measure of changes in U.S. stock market conditions based on the average performance of 500 widely held common stocks. The index includes large industrial, financial, transportation and utility stocks. The composition of the index, determined by Standard & Poor’s, varies over time. Announcement that a company is being added to the S&P 500 usually boosts the price of the company’s stock. This is a result of the influence of the S&P 500 on investing. In 2000, over $1 trillion worth of investors’ funds were indexed to the S&P 500, meaning mutual-fund managers were committed to purchasing a portfolio of stocks that matched the index. Adding a stock to the index increases demand for that company’s stock. Likewise, removal of a stock from the index results in the sale of that stock by index-fund managers. In addition to the S&P 500 Index, Standard & Poor’s also publishes 90 other market and industry indexes.
Like Moody’s ratings, Standard & Poor’s also maintains a rating system for bonds, commercial paper, and other financial securities. The S&P bond-rating system ranks bonds from AAA to D, with AAA having the lowest default risk and D, the highest default risk. Any bond rated BBB or above is considered investment grade, with relatively low risk of default. Any bond rated below BBB is considered speculative grade and is referred to as a “junk bond” in U.S. financial markets.
The distinction between investment-grade and speculativegrade bonds is important, because many investment groups (mutual funds, commercial banks, insurance companies, and pension funds) direct their investment managers to only purchase investment-grade bonds. S&P bond ratings are based on the firm’s expected cash flow, other contractual obligations, the firm’s past profitability, and variability of the firm’s earnings. Bonds receiving higher ratings will be purchased at lower interest-rate yields by investors, saving companies considerable sums in financing costs. Lower-rated securities must offer investors a higher interest-rate yield because of the potential for default. Corporate and municipal bonds typically pay higher interest yields than the U.S. Treasury bond of the same maturity, and the lower the bond rating, the greater the spread between its yield and that of comparable Treasury bonds. For example, in February 2001 high quality 10+ year corporate bonds were paying on average 7.05 percent, while comparable U.S. Treasury bonds yielded 5.59 percent, a spread of 1.46 percent. Medium-quality corporate bonds yielded 7.84 percent on average, 2.25 percent more than comparable U.S. Treasury securities.