Fixed Income

What is Credit Rating?

Definition

A credit rating is an assessment by a rating agency (S&P, Moody's, Fitch) of a borrower's ability to repay debt. Ratings range from AAA (highest quality) to D (default), with investment grade (BBB- or above) and speculative grade (BB+ or below) as the key dividing line.

Detailed Explanation

The three major rating agencies — S&P Global Ratings, Moody's, and Fitch — evaluate the creditworthiness of corporations, governments, and structured financial products. Their ratings directly affect borrowing costs: a one-notch downgrade can increase a company's borrowing rate by 25-50 basis points, costing millions in additional interest on large debt loads.

Investment-grade ratings (BBB-/Baa3 and above) grant access to a much larger pool of investors. Many pension funds, insurance companies, and mutual funds are restricted to investment-grade bonds. A downgrade from BBB- to BB+ (fallen angel) can trigger forced selling, creating a price cliff. This is why companies guard their investment-grade ratings carefully.

The rating scale for S&P runs: AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, BB+, BB, BB-, B+, B, B-, CCC+, CCC, CCC-, CC, C, D. Moody's uses a slightly different system: Aaa, Aa1, Aa2, etc. As of 2024, only two U.S. companies maintain AAA ratings (Microsoft and Johnson & Johnson).

Credit ratings have faced criticism since the 2008 financial crisis, when agencies rated mortgage-backed securities AAA shortly before they defaulted. Conflicts of interest (issuers pay for their own ratings), slow reactions to deteriorating conditions, and procyclical effects remain concerns. Despite this, ratings remain integral to the fixed-income market's infrastructure.

Frequently Asked Questions

What happens when a company's credit rating is downgraded?

Downgrades increase borrowing costs, can trigger covenant violations in existing debt, and may force selling by investors restricted to higher-rated bonds. A downgrade from investment grade to junk (fallen angel) is particularly impactful, as it can exclude the company from major bond indices and trigger widespread forced selling.

How reliable are credit ratings?

Ratings are generally useful as relative measures of credit risk — higher-rated bonds default less frequently. However, they are lagging indicators and can miss rapid deterioration. Enron was investment-grade days before bankruptcy. Investors should use ratings as a starting point, not a substitute for their own analysis.

Related Terms

Debt-to-Equity Ratio

The Debt-to-Equity (D/E) ratio measures a company's financial leverage by comparing its total liabilities to shareholders' equity. It indicates how much debt a company uses to finance its operations relative to the value of shareholders' investment.

Yield Curve

The yield curve is a graph plotting bond yields across different maturities, from short-term (3 months) to long-term (30 years). A normal curve slopes upward, an inverted curve slopes downward, and inversions have preceded every U.S. recession since 1955.

Bond Yield

Bond yield is the return an investor earns from holding a bond, expressed as an annual percentage. The most common measure is yield to maturity (YTM), which accounts for the bond's coupon payments, price, par value, and time remaining until maturity.

Junk Bonds (High-Yield Bonds)

Junk bonds, officially called high-yield bonds, are debt securities rated below investment grade (BB+ or lower by S&P). They offer higher yields to compensate investors for greater default risk and are issued by companies with weaker financial profiles or higher leverage.

See It in Action

Apple

Microsoft

Johnson & Johnson

Berkshire Hathaway

Disclaimer: The information on this page is provided for educational and informational purposes only and does not constitute investment advice. AI-generated analysis may contain errors or inaccuracies. Always conduct your own research and consult a qualified financial advisor before making investment decisions.