In August 2011, Standard & Poor’s lowered the long-term credit rating of the United States from AAA to AA+, the first downgrade of its kind for the country. The move followed concerns about rising debt and the political turmoil surrounding the debt-ceiling fight.
The event raised an important question. If a borrower as central to the global financial system as the United States could lose its top rating, those familiar letter grades clearly meant more than a routine label. Understanding what AAA, AA, BBB, or BB actually signal, and where their limits begin, is essential to reading bond risk properly.
What a Credit Rating Actually Is
A credit rating is an assessment of a borrower’s ability and willingness to meet its financial obligations as promised. Think of it as a financial report card, except instead of grading academic performance, it grades relative credit risk.
Ratings are assigned by credit rating agencies, companies that analyze borrowers and debt securities and publish their conclusions. Three agencies dominate the global ratings business and are commonly known as the Big Three:
Standard & Poor’s (S&P) traces its roots to 1860, when Henry Varnum Poor began publishing financial information about U.S. railroads for investors. It is now part of S&P Global.
Moody’s Investors Service began systematically rating railroad bonds under John Moody in 1909, helping establish the approach that developed into modern bond ratings.
Fitch Ratings, the smallest of the three, was founded in 1913 and is now wholly owned by Hearst.
These three companies rate governments, corporations, municipalities, financial institutions, and structured finance securities around the world. Together, they account for about 93% of outstanding credit ratings in the United States.
The Rating Scales: Learning the Alphabet
Each agency uses slightly different symbols and definitions, but the scales follow the same broad pattern: ratings move from stronger credit quality at the top toward greater credit risk and, eventually, default at the bottom.
Here is how the major long-term rating scales broadly compare:
Investment Grade
| Credit quality | S&P | Moody’s | Fitch |
|---|---|---|---|
| Highest | AAA | Aaa | AAA |
| Very strong | AA+, AA, AA− | Aa1, Aa2, Aa3 | AA+, AA, AA− |
| Strong | A+, A, A− | A1, A2, A3 | A+, A, A− |
| Adequate | BBB+, BBB, BBB− | Baa1, Baa2, Baa3 | BBB+, BBB, BBB− |
Speculative Grade
| Credit quality | S&P | Moody’s | Fitch |
|---|---|---|---|
| Speculative | BB+, BB, BB− | Ba1, Ba2, Ba3 | BB+, BB, BB− |
| Highly speculative | B+, B, B− | B1, B2, B3 | B+, B, B− |
| Very high credit risk | CCC range | Caa range | CCC range |
| Near or in default | CC, C, D | Ca, C | CC, C, RD, D |
The lowest rating categories do not map perfectly across agencies, so the scales should be treated as broad equivalents rather than exact translations.
One boundary matters especially:
- BBB− / Baa3 and above are investment grade.
- BB+ / Ba1 and below are speculative grade, commonly called high yield or junk.
The top of the scale is unusually exclusive. Microsoft and Johnson & Johnson are among the few companies that hold an AAA rating from S&P. Even the U.S. government no longer holds the highest rating from any of the three major agencies.
The Company and the Bond Can Have Different Ratings
A company’s credit rating and the rating on a particular bond are not always the same.
An issuer credit rating reflects the agency’s assessment of the borrower’s overall creditworthiness. An issue credit rating applies to a specific bond and can also reflect factors such as seniority, collateral, guarantees, or expected recovery if the issuer defaults.
As a result, two bonds from the same company can sometimes carry different ratings. Senior secured debt, for example, may be rated differently from subordinated debt because the two claims do not have the same position if the company runs into financial trouble.
How Ratings Are Assigned
A credit rating is not produced by a single ratio or formula. It combines financial analysis with judgment.
The process commonly includes:
Quantitative analysis Analysts examine measures such as debt and leverage, interest coverage, cash flow, liquidity, profitability, and other financial indicators relevant to the borrower and its industry.
Qualitative analysis Numbers alone do not determine the rating. Analysts also consider factors such as competitive position, business stability, industry risks, regulation, management strategy, and financial policy. Two companies with similar financial ratios can therefore receive different ratings.
Management discussions Analysts often meet directly with an issuer’s management to discuss strategy, financial plans, risks, funding needs, and other information relevant to the credit assessment.
Rating committee
The analytical team presents its findings to a rating committee. The final rating is determined through the agency’s committee process rather than by a single analyst.
Once a rating is assigned, the agency continues monitoring the credit and can revise its assessment as financial conditions, business prospects, or other relevant factors change.
Agencies may also attach a Positive, Stable, or Negative outlook to indicate the possible direction of the rating over time. An outlook provides additional context but does not guarantee that the rating will change.
What a Rating Change Can Do to a Bond’s Price
Rating changes can move markets, sometimes sharply.
When an agency downgrades a bond, it signals a higher assessment of credit risk. If that deterioration is not already reflected in the market, investors may demand a higher yield to hold the bond, putting downward pressure on its price. The effect can be greater when the downgrade crosses the investment-grade/high-yield boundary.
Fallen angels, bonds downgraded from investment grade to high yield, can face particularly strong selling pressure. Some bond funds, indexes, insurers, pension funds, and other institutional mandates restrict or limit holdings below investment grade. Crossing the boundary can therefore cause some investors to reduce or sell their positions, adding to downward pressure on the bond’s price.
Ford Motor Company provides a useful example. Moody’s had already lowered Ford below investment grade in September 2019. Then, as the COVID-19 pandemic disrupted operations and weakened the company’s outlook, S&P lowered Ford from BBB− to BB+ on March 25, 2020. With both Moody’s and S&P now rating Ford below investment grade, roughly $35 billion of Ford debt became ineligible for investment-grade indexes. Fitch later lowered Ford to BB+ as well.
Conversely, rising stars, bonds upgraded from high yield to investment grade, can benefit from a broader pool of eligible investors. New investment-grade buyers may become eligible to own them, potentially increasing demand and supporting prices.
The 2008 Failure: When the System Broke Down
The financial crisis exposed the most serious failure in the modern history of credit ratings.
In the years before 2008, lenders made large volumes of subprime mortgages, including loans to borrowers with weak credit histories. Wall Street firms pooled mortgages into residential mortgage-backed securities (RMBS), while other structured products, including collateralized debt obligations (CDOs), were often built from pieces of mortgage-backed securities and other debt.
Rating agencies assigned AAA ratings to large quantities of this structured debt. To investors, that familiar label suggested exceptionally strong credit quality. But many of the underlying mortgages proved far riskier than the ratings implied.
Several weaknesses contributed to the problem. Rating models did not adequately capture how newer, riskier mortgage products would perform under severe housing stress. At the same time, the agencies were generally paid by the firms bringing the securities to them for ratings. This issuer-pays model created a structural conflict of interest because agencies depended on issuers for business while competing with one another to rate their deals.
As mortgage delinquencies and losses climbed, the ratings began to unravel. In July 2007, Moody’s and S&P announced mass rating actions affecting hundreds of subprime mortgage securities. The downgrades accelerated through 2007 and 2008, leaving investors and financial institutions holding billions of dollars of securities whose ratings and market values had deteriorated sharply. Eventually, 91% of AAA-rated subprime RMBS issued in 2007 and 93% of those issued in 2006 were downgraded to junk.
The Financial Crisis Inquiry Commission later concluded that failures at the rating agencies were “essential cogs in the wheel of financial destruction.” Major settlements followed: S&P agreed to pay $1.375 billion in 2015, while Moody’s reached an $864 million settlement in 2017 over conduct involving mortgage-related securities.
Reforms followed as well. The Dodd-Frank Act and subsequent SEC rules strengthened oversight of rating agencies, including requirements covering internal controls, conflicts of interest, rating methodologies, and disclosure. But the basic issuer-pays model survived: major agencies can still be paid by the issuers or arrangers whose securities they rate.
Why Sovereign Ratings Are Different
Government bonds add dimensions that corporate ratings do not. Sovereign analysis can include fiscal strength, debt levels, economic performance, political institutions, external finances, and the country’s monetary framework.
One important distinction is monetary flexibility. A country that borrows mainly in a currency it controls generally has more policy flexibility than one that does not. Japan, for example, carries public debt above 200% of GDP yet remains investment grade. Greece, by contrast, entered its debt crisis as a member of the euro area. It borrowed in euros but did not control monetary policy independently, leaving it without the same flexibility when financing conditions deteriorated.
Ratings in Practice: What Investors Actually Do With Them
Despite their limitations, ratings remain deeply embedded in how bond markets function. The key is to use them as one source of information rather than the final word.
Use ratings as a starting point, not a conclusion. A BBB rating tells you where the agency places the bond or issuer within its credit-risk scale. It does not tell you whether the bond is fairly priced, whether conditions are improving or deteriorating, or whether the potential return adequately compensates you for the risks.
Watch the direction, not just the letter grade. A bond rated BBB− with a Negative outlook is in a different position from one rated BBB− with a Stable outlook. Rating outlooks, recent upgrades or downgrades, and the agency’s written rationale can provide useful context about where credit quality may be heading.
Remember that ratings can lag. Rating agencies do not always identify deterioration before the market does. Enron remained investment grade until just four days before its 2001 bankruptcy. Lehman Brothers was still rated investment grade by the three major agencies when it filed for bankruptcy in September 2008.
Sources and Further Reading
- U.S. Securities and Exchange Commission / Investor.gov — Updated Investor Bulletin: The ABCs of Credit Ratings
- SEC — Nationally Recognized Statistical Rating Organizations (NRSROs)
- S&P Global Ratings — Understanding Credit Ratings
- Moody’s — Credit Ratings
- Fitch Ratings — Rating Definitions
- Ford Motor Company — Form 10-Q for the quarter ended March 31, 2020
- U.S. Senate Permanent Subcommittee on Investigations — Credit Rating Agencies and the Financial Crisis
- Financial Crisis Inquiry Commission — The Financial Crisis Inquiry Report