If a financial institution is backed by any government program or indirect guarantee, any bonds purchased must be "rated" at investment grade or better. The rating agency is a third party with no connections with the bond issuer or the bond investor. Which of the following is a true statement. (Points: 4)
The rating agency is a government entity or agency.
The rating agency has a perfect record in determining which bond will fail.
The use of a rating agency is a perfect example of the principal-agent relationship by utilizing independent sources as quality-rating entities.
Only AAA rate bonds are investment grade.
Once rated, a bond will never change rating classification.
All but one of the above are correct.
The statement that is true is: "The use of a rating agency is a perfect example of the principal-agent relationship by utilizing independent sources as quality-rating entities."
To determine the correct answer, we need to analyze each statement:
1. The rating agency is a government entity or agency: This statement is not true. The question states that the rating agency is a third party with no connections to the bond issuer or investor, implying that it is an independent organization and not a government entity.
2. The rating agency has a perfect record in determining which bond will fail: This statement is not true. No rating agency has a perfect record in predicting bond failures. Ratings are based on the agency's assessment of the creditworthiness of a bond issuer, but they cannot guarantee accurate predictions of bond performance.
3. The use of a rating agency is a perfect example of the principal-agent relationship by utilizing independent sources as quality-rating entities: This statement is true. The principal-agent relationship refers to a situation where one party (the principal) delegates authority to another party (the agent) to act on their behalf. In this case, the financial institution (the principal) relies on the rating agency (the agent) to provide an independent assessment of the quality or creditworthiness of the bonds they purchase.
4. Only AAA rate bonds are investment grade: This statement is not true. While AAA-rated bonds are considered the highest investment grade, there are other rating categories, such as AA, A, and BBB, that are also considered investment grade. Ratings below BBB are considered speculative or non-investment grade.
5. Once rated, a bond will never change rating classification: This statement is not true. Bond ratings are not permanent and can change over time based on the issuer's financial health and creditworthiness. Rating agencies continuously monitor the bonds they have rated and may revise the ratings if they deem necessary.
Based on the analysis, all statements except for "The use of a rating agency is a perfect example of the principal-agent relationship by utilizing independent sources as quality-rating entities" are incorrect.