Bond Ratings
You now know how to measure yields and calculate accrued interest. But yield alone does not tell you the full story. You also need to know how likely the issuer is to pay. That is where bond ratings come in. Credit ratings assess default risk and directly influence the yield an issuer must offer.
Rating Agencies
The three major rating agencies are:
- Standard & Poor's (S&P)
- Moody's
- Fitch
Key facts:
- Ratings assess the credit quality (likelihood of default) of a bond issuer or specific issue
- Ratings are opinions, not guarantees, of creditworthiness
- Issuers pay the rating agencies for ratings (issuer-pay model)
Exam Tip: Gotchas
- Ratings are opinions, not guarantees. A AAA-rated bond can still default. The rating reflects the agency's assessment of credit risk at the time, not a promise of repayment.
Rating Scales
| Quality | S&P / Fitch | Moody's | Grade |
|---|---|---|---|
| Highest quality | AAA | Aaa | Investment grade |
| High quality | AA+, AA, AA- | Aa1, Aa2, Aa3 | Investment grade |
| Upper medium | A+, A, A- | A1, A2, A3 | Investment grade |
| Medium | BBB+, BBB, BBB- | Baa1, Baa2, Baa3 | Investment grade |
| Speculative | BB+, BB, BB- | Ba1, Ba2, Ba3 | Non-investment grade ("junk") |
| Highly speculative | B+, B, B- | B1, B2, B3 | Non-investment grade |
| Substantial risk | CCC+ to C | Caa1 to C | Non-investment grade |
| Default | D | -- | Default |
The Investment-Grade Dividing Line
This is the single most tested rating concept on the exam:
- Investment grade: BBB-/Baa3 and above
- Non-investment grade (high-yield/junk): BB+/Ba1 and below
- S&P and Fitch use +/- modifiers; Moody's uses 1/2/3 modifiers
Exam Tip: Gotchas
- The BBB-/Baa3 to BB+/Ba1 boundary is the most tested rating concept. A single-notch downgrade from BBB- to BB+ crosses the investment-grade line and can cause a disproportionately large price drop because many institutional investors (pension funds, insurance companies, banks) are prohibited from holding non-investment-grade bonds and must sell.
Rating Impact on Price and Yield
Credit ratings and market pricing are directly connected:
| Rating Change | Effect on Price | Effect on Yield |
|---|---|---|
| Upgrade | Price rises | Yield falls |
| Downgrade | Price falls | Yield rises |
- Higher-rated bonds have lower yields (less risk requires less compensation)
- Lower-rated bonds have higher yields (more risk requires more compensation)
- The difference in yield between two rating categories is called the credit spread (or yield spread)
Think of it this way: A credit rating works like a credit score for bonds. Just as a borrower with a low credit score pays a higher interest rate on a loan, a bond issuer with a low rating must offer a higher yield to attract buyers. The gap between what a safe issuer pays and what a risky issuer pays is the credit spread.
Credit Spreads and the Economy
- Credit spreads widen during economic downturns (investors demand more compensation for risk; this is called "flight to quality")
- Credit spreads narrow during economic expansions (investors are more willing to accept risk)
Exam Tip: Gotchas
- Credit spreads widen in bad times and narrow in good times. When the economy weakens, investors demand higher yields on lower-rated bonds, pushing spreads wider. The reverse happens during expansions.
- A rating downgrade does not always mean default. It means increased risk. But a downgrade from BBB- to BB+ triggers forced institutional selling (see above), which amplifies the price drop beyond what the credit risk alone would justify.