Understanding Credit Ratings and Rating Agencies | CFA Level I Fixed Income

In this lesson, we’re going to explore credit ratings and the role of credit rating agencies in the Fixed Income world.

How Credit Ratings Work

Credit rating agencies assess the credit quality of both issuers and individual debt issues, assigning ratings based on their risk of default:

• AAA is the highest rating.
• Investment grade bonds have ratings of triple B- or higher.
• Non-investment grade bonds, also called high yield or junk bonds, are rated BB+ or lower.
• Bonds in default are rated D by Standard & Poor’s and Fitch, and C by Moody’s.

Issuer credit ratings, known as corporate family ratings, are based on the overall creditworthiness of a company and its senior unsecured debt. Issue-specific ratings, or corporate credit ratings, depend on the seniority of a bond issue and its covenants.

Risks of Relying on Credit Ratings

While credit ratings can be useful, over-reliance on them can be risky. Here are four specific risks:

1. Dynamic ratings: Credit ratings change over time, so investors should not assume that ratings will remain constant.
2. Latency in ratings: Ratings may be updated after market prices have already moved in response to credit events, so waiting for rating changes before making investment decisions can result in underperformance.
3. Unpredictable events: Events like litigation risk, natural disasters, and leveraged transactions can be difficult to assess and incorporate into credit ratings.
4. Rating agency mistakes: Ratings errors, like the US subprime MBS ratings in the mid-2000s, can have significant consequences.