Bonds & Interest Rates · Intermediate · 4 min

Credit quality and ratings

You can read bond credit ratings, find the line between investment grade and high yield, and explain what a rating does and does not tell you.

Grades for borrowers

Before lending money to a company, a bank studies its accounts. A private investor buying a bond rarely has the time or the data to do the same. That is where credit ratings come in.

Ratings look like school grades: AAA, A, BBB, BB. In a sense they are: grades for how likely a borrower is to pay its debts on time. This lesson explains the scale, the one line on it that matters most, and the limits of any rating.

The BBB− line

A credit rating is an assessment of a borrower's ability and willingness to repay. It is published by credit rating agencies. In the US, the SEC registers and examines them as NRSROs. The SEC's bulletin is clear that it does not regulate the substance of ratings or the methods the agencies use.

The three largest agencies use similar letter scales. At S&P and Fitch, ratings run from AAA, the highest, through AA, A, BBB, BB, B and lower, down to D for default. Moody's uses Aaa, Aa, A, Baa, Ba, B and so on, with numbers 1 to 3 as steps within a grade. S&P and Fitch use plus and minus.

The most important line runs between BBB− and BB+, or Baa3 and Ba1 at Moody's:

Investment grade: BBB− and above. Investor.gov describes investment grade bonds as issued at lower yields than less creditworthy bonds.
High yield: BB+ and below. A high-yield bond, also called a junk bond, typically pays a higher yield to compensate for the added risk.

The line matters in practice. Many funds and institutions may only hold investment grade bonds. When a company is downgraded across the line, these holders may have to sell, which can push prices down further.

Ratings are opinions, not promises. They can change, and they can lag behind events. The SEC's bulletin advises investors not to rely on ratings alone.

Fallen angel

A fictional company has been rated BBB− for years. After two weak years, an agency downgrades it to BB+.

Its bonds are now high yield. Some funds that may only hold investment grade bonds have to sell.
Within a week, its bonds fall about 6%, and their yield rises.
Investors who can hold high-yield bonds now earn a higher yield on the same company.

Bonds that drop from investment grade to high yield are called fallen angels. The company itself changed slowly. The price moved suddenly.

Common mistakes

Treating a rating as a promise. It is an opinion that can change.
Ignoring the BBB− line. Crossing it can trigger forced selling.
Chasing yield in low ratings. Higher yield is payment for higher risk.
Relying on ratings alone. They are one input, not a full analysis.

The takeaway

Ratings grade how likely a borrower is to pay. BBB− and above is investment grade, below is high yield. A rating is an opinion, not a promise.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the group a bond rated BB belongs to.

Tap the chart.

BB is below BBB−, so it is non-investment grade, also called high yield or junk.
2What is the lowest S&P or Fitch rating that still counts as investment grade?

The SEC's bulletin on credit ratings: BBB− or higher is investment grade, lower is non-investment grade.
3Does the SEC decide what rating a bond gets?

Ratings come from registered agencies, called NRSROs. The SEC examines them but does not set ratings.
4A company is downgraded from BBB− to BB+. What often happens to its bond prices?

A downgrade below investment grade can force some funds to sell, which adds pressure on prices.

of 4 correct.