Credit Ratings

A credit rating is an opinion from a rating agency about how likely a borrower is to repay its debts on time. The three largest agencies, S&P Global Ratings, Moody's and Fitch Ratings, rate governments, companies, municipalities and structured products. Ratings influence borrowing costs, determine which bonds many institutions can hold and move markets when they change. They are useful summaries, but they are opinions, not guarantees, and they have been badly wrong at times.

Rating scales#

BBB minus (Baa3) and above is investment grade; BB plus (Ba1) and below is high yield. See Investment Grade vs High-Yield Bonds.

Default rates by rating#

Historical data from the agencies shows a strong link between ratings and defaults.

Approximate long run averages from S&P and Moody's default studies for corporate issuers; actual rates vary by period and source. See Default Probability and Recovery Rate.

What agencies analyse#

• Business risk: industry, competitive position, scale.
• Financial risk: leverage, interest coverage, cash flow, liquidity. See Operating and Financial Leverage.
• Management and governance.
• Country and sovereign risk.
• Structure: seniority, collateral and covenants of the specific bond.

Outlooks and watches#

Agencies signal possible changes:

• Outlook (positive, negative, stable): direction of a rating over the next one to two years.
• CreditWatch or review: a change may come soon, often after a major event.

Why ratings matter#

Criticisms and failures#

• The 2008 crisis: agencies gave AAA ratings to many mortgage backed securities and collateralised debt obligations that later suffered huge losses. The US Financial Crisis Inquiry Commission called the agencies "key enablers" of the crisis. See The 2008 Financial Crisis.
• Conflicts of interest: under the "issuer pays" model, borrowers pay for their own ratings.
• Slow to react: ratings often change after market prices have already moved; Enron was rated investment grade until days before its 2001 bankruptcy.
• Sovereign controversies: downgrades of the US (S&P 2011, Fitch 2023, Moody's 2025) and European countries during the debt crisis drew criticism.

Using ratings wisely#

• Treat ratings as a starting point, not a final answer.
• Watch market spreads, which react faster than ratings.
• Understand what is rated: the issuer, a specific bond or a structured tranche.

Frequently asked questions#

What is a credit rating?#

An opinion from a rating agency on a borrower's ability to repay its debt on time, expressed on a letter scale from AAA to D.

What is the difference between investment grade and high yield?#

Investment grade bonds are rated BBB minus (Baa3) or higher; high yield bonds are rated BB plus (Ba1) or lower and carry higher default risk.

Are credit ratings reliable?#

They are correlated with default rates over long periods, but they can be slow to change and failed badly for structured products before 2008.

Next, learn how bond returns are measured in Yield to Maturity.