Credit ratings: uses and limitations

What is a credit rating?

A credit rating is a letter grade that gives an agency’s opinion on how likely a bond or issuer is to default and how much an investor might lose if it does. The three big agencies are Moody’s, Standard & Poor’s (S&P) and Fitch. Most corporate and government bonds carry ratings from two or more of them. Each rating looks forward and blends financial numbers with judgment.

The scales look alike. This is the long-term scale (for bonds with more than one year to maturity):

Grade	Moody’s	S&P and Fitch
Highest quality	Aaa	AAA
High quality	Aa1, Aa2, Aa3	AA+, AA, AA−
Upper medium	A1, A2, A3	A+, A, A−
Lower medium (lowest investment grade)	Baa1, Baa2, Baa3	BBB+, BBB, BBB−
Speculative (high yield)	Ba1 to B3	BB+ to B−
Very high risk	Caa1 to Ca	CCC+ to C
In default	C (likely in default)	D

The one line to learn is where the market splits. Bonds rated Baa3 / BBB− or higher are investment grade . Bonds rated Ba1 / BB+ or lower are high yield , also called speculative grade, non-investment grade, below investment grade or junk. Investment-grade issuers can usually borrow more cheaply and more consistently, and their bonds are less hurt by bad economic news and suit portfolios with quality limits.

Long-term credit ratingsMoody's on the left, S&P and Fitch on the right

• Investment grade Memorize Baa3 / BBB− or higher
  • Aaa / AAA Memorize highest credit quality, lowest credit risk
  • Aa1–Aa3 / AA+ to AA− Memorize very high quality
  • A1–A3 / A+ to A− Memorize upper medium; high quality
  • Baa1–Baa3 / BBB+ to BBB− Memorize lower medium; the last investment-grade steps
• High yield Memorize Ba1 / BB+ or lower; also speculative, non-investment grade, junk
  • Ba1–Ba3 / BB+ to BB− Use it speculative, substantial credit risk
  • B1–B3 / B+ to B− Use it highly speculative
  • Caa1–Caa3 / CCC+ to CCC− Use it default a real possibility
  • Ca / CC, C Use it default occurring or about to
• In default Use it D at S&P and Fitch; Moody's lowest rating, C, means likely in default

An agency can also publish a rating outlook , positive or negative, when creditworthiness is improving or worsening but a rating change is not yet warranted. A “review for downgrade” is a stronger version of the same signal.

Exam tip When the question says “just below investment grade”, think BB+ or Ba1. When it says “lowest investment grade”, think BBB− or Baa3.

How are ratings used?

Ratings give a quick, comparable view of credit quality across issuers, industries and countries. They also have legal weight: they appear in regulatory capital rules, investment mandates (“investment grade only”), covenants and step-up coupons that rise when the issuer is downgraded.

Uses of credit ratingsa shortcut with legal weight

• Comparing credit risk Use it across issuers, industries and countries
• Rules and contracts Use it regulatory capital, "investment grade only" mandates, covenants, step-up coupons
• Signalling change Use it upgrades, downgrades and outlooks show where credit conditions are heading

A downgrade matters because of credit migration risk , also called downgrade risk: the risk that an issuer’s creditworthiness deteriorates and its rating migrates lower. Investors then believe default is likelier, the bond’s yield spread widens and its price falls.

Under the issuer-pay model , the issuer pays for the rating. To prepare it, the agency often meets management and may receive material non-public information, such as financial projections. Regulation after the 2008–2009 financial crisis made agencies more transparent and reduced some conflicts of interest, and newer and local agencies have appeared, but the issuer-pay model and the dominance of the big three remain.

Go deeper Why outlooks track prices better than ratings

An outlook is a lighter commitment than a rating change. An agency can attach a negative outlook as soon as the picture worsens, while a downgrade needs firmer evidence. Because outlooks react earlier, they line up more closely with how the market prices the issuer. Investors who wait for the rating itself to change often trade after the price has already moved.

Why shouldn’t you rely on ratings alone?

Most investors run their own analysis as well, particularly in high yield or when a downgrade is likely. There are four reasons.

Limits of credit ratingsdo your own analysis, especially in high yield

• They lag the market Memorize spreads move daily, ratings rarely
• Some risks are hard to rate Memorize litigation, environmental damage, disasters, debt-funded deals
• Agencies can split Memorize different ratings on the same issuer
• Ratings can be wrong Memorize missed shocks and accounting fraud

1. Ratings lag the market. Credit spreads change daily. Ratings change rarely and deliberately, and even over long periods they trail prices. Here is a story with invented numbers:

Prices and ratings measure slightly different things, too. Ratings try mainly to estimate expected loss, while the price of distressed debt reflects the timing of default and the likely recovery. So two bonds with the same rating can trade at very different spreads.

2. Some risks are hard to capture. Litigation, environmental damage and natural disasters are hard to forecast. So are leveraged transactions that change the capital structure suddenly, such as a debt-funded acquisition or a large debt-funded share buyback.

3. Agencies can disagree. Complex or new issuers can receive split ratings . An issuer might be rated B by one agency and BB by another. That is not a mistake by one of them. It is a real difference of view on a hard credit.

4. Ratings can be wrong. Models can miss what nobody forecast. Highly rated mortgage bonds defaulted when housing prices fell sharply in 2008–2009, and complex accounting frauds supported high ratings at companies that later failed.

Go deeper Issuer ratings, issue ratings and notching

An agency rates the issuer and also the individual bond. A senior secured bond can be rated above its issuer’s rating, and a subordinated bond below it. The gap between the two is called notching. It is covered with corporate credit analysis, not here.