Bond Ratings and Rating Agencies
Understanding how bonds are priced and how they react to interest rates is essential. But there's another dimension of risk that affects pricing: credit risk. Bond ratings provide a standardized way to assess how likely an issuer is to pay you back.
The Three Major Rating Agencies
| Agency | Headquarters | Notation Style |
|---|---|---|
| Moody's | New York | Uses numbers (Aaa, Aa1, Aa2, Baa3) |
| Standard & Poor's (S&P) | New York | Uses +/- signs (AAA, AA+, BBB-) |
| Fitch | New York/London | Uses +/- signs (same scale as S&P) |
Exam Tip: Gotchas
- Three agencies to know: Moody's, S&P, and Fitch. Moody's uses NUMBERS (Aaa, Baa3); S&P and Fitch use LETTERS with +/- (AAA, BBB-).
The Rating Scale
| Grade | S&P / Fitch | Moody's | Meaning |
|---|---|---|---|
| Highest quality | AAA | Aaa | Minimal credit risk |
| High quality | AA | Aa | Very low credit risk |
| Upper medium | A | A | Low credit risk |
| Medium | BBB | Baa | Moderate credit risk |
| Investment grade cutoff | BBB- and above | Baa3 and above | --- |
| Speculative | BB | Ba | Substantial credit risk |
| Highly speculative | B-CCC | B-Caa | High/very high credit risk |
| Default | D | C | In default |
Investment Grade vs. Speculative Grade
The dividing line between investment grade and speculative grade is the single most important distinction in credit ratings:
- Investment grade: BBB-/Baa3 and above
- Below investment grade (high-yield/junk): BB+/Ba1 and below
- Many institutional investors (pension funds, insurance companies) are restricted to investment-grade bonds only
- The rating directly affects the issuer's borrowing cost; lower ratings mean higher yields demanded by investors
Why the Cutoff Matters
- A downgrade from BBB- to BB+ (crossing the investment-grade line) can trigger forced selling by institutional investors
- This creates a sharp price drop for bonds that cross the line; sometimes called "fallen angels"
- Conversely, an upgrade from BB+ to BBB- can trigger significant buying interest
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.
Exam Tip: Gotchas
- BBB-/Baa3 is the LOWEST investment-grade rating (not BBB+/Baa1). The line falls at BBB-/Baa3, not higher.
Key Facts About Ratings
- Ratings assess credit (default) risk only, not interest rate risk or market risk
- Higher-rated bonds offer lower yields (less risk = less reward)
- Lower-rated bonds offer higher yields (more risk = more reward)
- Ratings can change over time as the issuer's financial condition changes
- U.S. Treasury securities are considered the benchmark for the highest credit quality
Think of it this way: Credit quality and yield move in opposite directions, like a seesaw. The safer the bond (higher rating), the less it needs to pay you to hold it. The riskier the bond (lower rating), the more it has to offer to attract buyers.
Exam Tip: Gotchas
- Bond ratings measure CREDIT risk only (not interest rate risk or market risk). A AAA-rated bond can still lose value if interest rates rise.
- Higher rating = LOWER yield. This inverse relationship between credit quality and yield is frequently tested.