Credit Rating
A credit rating is an independent assessment of the creditworthiness of a borrower — whether a corporation, government, or financial instrument — expressed as a letter grade that indicates the likelihood the borrower will repay its debt obligations on time and in full.
Credit ratings are issued by Nationally Recognized Statistical Rating Organizations (NRSROs), of which three dominate the market: Moody's Investors Service, S&P Global Ratings, and Fitch Ratings. Despite using slightly different notation, all three use a scale that distinguishes between 'investment grade' (higher quality, lower default risk) and 'speculative grade' or 'high yield' (also called 'junk') debt. S&P's investment-grade ratings run from AAA (highest) down through AA, A, and BBB; anything below BBB- is considered speculative grade.
For corporations, credit ratings directly determine borrowing costs. A BBB-rated company might borrow at Treasury yields plus 150 basis points, while a BB-rated 'junk' issuer might pay Treasury yields plus 400 basis points for the same maturity. Being downgraded from investment grade to speculative grade — a 'fallen angel' event — can be catastrophic: index funds and ETFs that are mandated to hold only investment-grade bonds are forced to sell, sometimes creating a vicious cycle of falling prices and rising yields for the affected issuer.
For sovereign borrowers, credit ratings affect the cost of financing government debt, the ability to access international capital markets, and sometimes the terms of IMF or World Bank lending. The 2011 S&P downgrade of U.S. long-term debt from AAA to AA+ — the first ever for the U.S. government — sent shockwaves through markets even though investors continued to treat Treasuries as the global safe-haven asset. A second S&P downgrade event did not follow, but the episode highlighted the psychological importance of ratings.
The rating agencies faced severe criticism after the 2008 financial crisis for awarding AAA ratings to mortgage-backed securities and collateralized debt obligations (CDOs) that were backed by subprime loans and ultimately defaulted en masse. Congressional investigations and the Dodd-Frank Act sought to reduce over-reliance on ratings in regulation, with mixed success. Understanding both the utility and the limitations of credit ratings is essential for fixed-income and multi-asset investors.