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How to Read Credit Ratings (Moody's, S&P)

In the news you see phrases like 'sovereign credit rating AAA' or 'corporate bond downgraded to BB+.' Let's learn how to read exactly what these letters mean and where the boundary of risk lies.

What is a credit rating

A credit rating is a report card that credit-rating agencies assign in alphabetical symbols, evaluating 'how capable this issuer is of repaying its borrowings on time.'

Globally, three firms are representative: Moody's, S&P Global, and Fitch. They assign ratings to individual countries, companies, and bonds, lowering the rating (a downgrade) when conditions worsen and raising it (an upgrade) when they improve.

The higher the rating, the 'lower the risk of not being paid back'; the lower the rating, the 'greater the risk.' So even for the same maturity, a lower-rated bond has to pay higher interest to sell.

The rating tables of Moody's and S&P/Fitch

The two camps have slightly different notations.

Moody's starts from the highest, Aaa, and goes down through Aa, A, Baa, Ba, B, Caa, Ca, and finally C, which is effectively a default state. Finer distinctions use the numbers 1, 2, 3 (e.g., Baa1 > Baa2 > Baa3).

S&P and Fitch start from AAA and go down through AA, A, BBB, BB, B, CCC, CC, C to D, the default state. Finer distinctions use + and - (e.g., BBB+ > BBB > BBB-).

The trick to reading them is simple. The more A's (AAA, Aaa), the top safety; the further down, the greater the risk.

Even for the same rating, an 'Outlook' may be attached. A 'negative' outlook hints at the possibility of a future downgrade, and a 'positive' one at the possibility of an upgrade. (Source: S&P Global, U.S. SEC investor guidance)

The most important single step: investment grade vs. speculative grade

In this rating table, the most important line is just one place—the boundary that divides investment grade from speculative grade.

Investment grade runs from the top down to BBB- (Moody's Baa3). It's the range considered relatively safe.

Everything from just below it, BB+ (Moody's Ba1), is speculative grade, commonly called high yield or junk bonds.

This 'single step between BBB- and BB+' is the most decisive line in the bond market. In Moody's long-term data, the 10-year cumulative default rate was about 4.6% for Baa, the bottom of investment grade, but jumped to about 19% for Ba, one step below. A single-step rating difference multiplies the risk several times.

Default rates are on Moody's 1970-2006 issuer-weighted 10-year cumulative basis and differ by compilation period. Pension funds, insurers, and others are often required by rules to hold only investment grade, so a downgrade below this boundary can trigger mass selling.

Why you shouldn't blindly trust ratings

A credit rating is a useful starting point, but it's not a perfect prophecy.

First, ratings are generally paid for by the side issuing the bond (companies, countries), who pay the agencies for them. Because of this structure, there has long been criticism that a conflict of interest is possible.

Second, ratings change after the fact. During the 2008 financial crisis, subprime-related products that had received top ratings went sour en masse, greatly exposing the limits of credit rating.

So a rating is not a certificate that 'this bond is absolutely safe' but a 'reference metric that gauges the risk at the current point in time.' Even a high rating can be downgraded, and a rating cannot perfectly prevent a future default.

よくある質問

Q. If it's rated AAA, will I never lose principal?

AAA (Aaa) is the highest rating with a historically very low default rate, but 'never' is not the word. Ratings can be downgraded over time, and even without a default, if rates rise the bond's price falls, so you can take a loss if you sell midway. A rating only tells you the size of default risk; it's not a guarantee that prevents all losses.

Q. If the ratings of Moody's, S&P, and Fitch differ, which do I trust?

It's common for the three agencies' ratings to diverge by about one notch. In such cases it's safer to refer to the more conservative (lower) rating, or to look at all three together. What matters is the attitude of checking multiple assessments and the issuer's actual financial condition together, rather than blindly trusting one agency's rating.