Bond Ratings
Now that you understand the different types of corporate bonds, you need to know how the market evaluates their creditworthiness. Bond ratings provide a standardized measure of default risk that drives investment decisions and regulatory requirements.
Credit Rating Agencies
Three agencies dominate bond ratings. These are sometimes called the "Big Three":
| Agency | Highest Rating | Investment Grade Range | Speculative (Junk) Range | Default |
|---|---|---|---|---|
| Standard & Poor's (S&P) | AAA | AAA to BBB- | BB+ to D | D |
| Moody's | Aaa | Aaa to Baa3 | Ba1 to C | C |
| Fitch | AAA | AAA to BBB- | BB+ to D | D |
Rating modifiers:
- S&P and Fitch use +/- (e.g., A+, A, A-)
- Moody's uses 1/2/3 (e.g., A1, A2, A3)
The critical dividing line:
- Investment grade: BBB-/Baa3 or higher; eligible for purchase by banks, insurance companies, and many institutional investors
- Speculative grade (high-yield/junk): BB+/Ba1 or below; higher default risk, higher yield
Think of it this way: The BBB-/Baa3 line is like a velvet rope. Above it, institutional money can flow freely. Below it, many large buyers are barred from purchasing, which limits demand and pushes yields higher.
Exam Tip: Gotchas
- BBB-/Baa3 is the LOWEST investment grade rating (not BBB+/Baa1). One notch below and it becomes junk.
- S&P and Fitch use +/- modifiers; Moody's uses 1/2/3. These are easy to confuse on the exam.
- Higher rating = lower yield. Less risk means less compensation needed.
What Ratings Measure (and What They Do Not)
Bond ratings assess the creditworthiness of the issuer: the likelihood of timely payment of interest and principal.
Ratings DO measure:
- Default risk (credit risk)
- The issuer's financial ability to meet debt obligations
Ratings do NOT measure:
- Interest rate risk
- Liquidity risk
- Market risk
- Reinvestment risk
Exam Tip: Gotchas
- Bond ratings measure DEFAULT risk only. A AAA-rated 30-year bond has minimal credit risk but significant interest rate risk. If the exam asks what a rating does NOT measure, the answer is interest rate risk, market risk, or liquidity risk.
Rating Changes and Their Effects
- A rating downgrade → bond price falls, yield rises
- A rating upgrade → bond price rises, yield falls
Fallen angels:
- Bonds rated BBB/Baa are the lowest investment grade
- Most sensitive to economic downturns
- A downgrade to BB/Ba creates a "fallen angel" (a bond that was investment grade but is now speculative)
- Many institutional holders are required to sell fallen angels due to investment policy restrictions, creating additional selling pressure
Memory Aid: Falling Angel
A bond downgraded from BBB-/Baa3 (lowest investment grade) to BB+/Ba1 (highest junk) is a falling angel. Institutional investors restricted to investment-grade bonds are forced to sell, often causing a sharp price drop beyond what the credit deterioration alone would justify.
Exam Tip: Gotchas
- A fallen angel was investment grade but got downgraded to junk. The forced selling by institutional holders can cause the price to drop even further than the credit deterioration alone would justify.
- Rating changes affect price and yield inversely. A downgrade pushes the price down and the yield up. The exam may test whether you know the direction of both moves.