Bond Rating

Bond ratings serve as a critical information intermediary in debt markets. The global debt market encompasses an enormous number of issuers ranging from sovereign governments and large multinational corporations to small municipalities and emerging market entities, many of which individual investors and even large institutional investors lack the resources to analyse independently. Ratings condense the complex credit analysis conducted by teams of specialised analysts into a single standardised symbol that communicates the agency’s assessment of credit risk to the entire market simultaneously, dramatically reducing the information asymmetry between issuers and investors.

The Rating Scales of the Major Agencies

The three major rating agencies use parallel but not identical rating scales. Understanding the correspondence between these scales and the categories they represent is essential for any fixed income professional.

For S&P Global Ratings and Fitch Ratings, the long-term rating scale begins at AAA, the highest possible rating, representing an issuer with an extremely strong capacity to meet its financial commitments. The next tier is AA, which includes AA+, AA, and AA-, representing very strong capacity. The A tier, including A+, A, and A-, represents strong capacity with some susceptibility to adverse economic conditions. The BBB tier, including BBB+, BBB, and BBB-, represents adequate capacity but with greater susceptibility to adverse conditions. These four tiers from AAA through BBB- constitute the investment grade ratings.

Below investment grade, S&P and Fitch use BB+, BB, and BB- for the highest speculative grade tier, representing obligations that are less vulnerable in the near term but face ongoing major uncertainty. The B tier represents obligations that are more vulnerable to adverse conditions but currently have capacity to meet commitments. The CCC, CC, and C tiers represent obligations that are currently vulnerable to non-payment, highly vulnerable, and imminently at risk of default respectively. The D rating indicates that payment default has already occurred.

Moody’s uses a parallel but differently labelled scale. The investment grade ratings begin at Aaa at the top, followed by Aa1, Aa2, and Aa3, then A1, A2, and A3, then Baa1, Baa2, and Baa3 at the bottom of investment grade. The speculative grade categories begin with Ba1, Ba2, and Ba3, followed by B1, B2, and B3, then Caa1, Caa2, and Caa3, followed by Ca and C. Moody’s does not use a D rating for default; instead Ca and C indicate obligations in or very near default.

The critical dividing line in the rating scale is the boundary between investment grade and speculative grade, which falls between BBB- and BB+ on the S&P and Fitch scales and between Baa3 and Ba1 on the Moody’s scale. This boundary has enormous practical significance because many institutional investors including pension funds, insurance companies, and certain regulated investment vehicles are restricted by their investment guidelines or by regulation from holding securities rated below investment grade. A rating downgrade that takes a bond from the lowest investment grade tier to the highest speculative grade tier, commonly called a fallen angel, triggers mandatory selling by these constrained investors regardless of the bond’s actual market price or the manager’s own credit assessment, creating the potential for sharp price dislocations at the investment grade boundary.

The Rating Process

The credit rating process is a structured analytical exercise conducted by teams of specialised analysts within the rating agency. For corporate issuers, the process typically involves several key stages.

The analytical team reviews the issuer’s financial statements including income statements, balance sheets, cash flow statements, and footnote disclosures for a period of typically five years or more. They calculate and analyse key financial ratios including leverage ratios measuring the level of debt relative to earnings and assets, coverage ratios measuring the issuer’s ability to service its debt obligations from operating cash flow, liquidity ratios assessing the issuer’s ability to meet near-term obligations, and profitability ratios measuring the efficiency with which the issuer generates earnings from its assets and equity.

Beyond financial statement analysis, the analytical team assesses qualitative factors including the quality and depth of the management team, the competitive position of the company within its industry, the characteristics of the industry itself including its cyclicality, barriers to entry, and growth prospects, the issuer’s business diversification across products, customers, and geographies, and the regulatory and legal environment in which the company operates. For corporate issuers, the assessment of business risk and financial risk together determines the anchor rating from which the final rating is derived through the application of various modifiers.

For sovereign issuers, the analytical framework differs substantially, with emphasis on macroeconomic factors including GDP growth, inflation, fiscal deficit and debt levels, monetary policy frameworks, current account balances, foreign currency reserve adequacy, political stability, and institutional quality. Sovereign ratings are complicated by the distinction between foreign currency ratings, which assess the ability to service debt denominated in currencies other than the sovereign’s own, and local currency ratings, which assess the ability to service debt denominated in the sovereign’s own currency. Local currency ratings are typically one or two notches higher than foreign currency ratings because a sovereign that controls its own currency can in principle always generate the local currency needed to service local currency debt, though at the cost of potential inflation.

The rating committee process is the mechanism through which the final rating decision is made. The analytical team presents its findings and recommendation to a rating committee composed of senior analysts and committee members, who debate the analysis and vote on the appropriate rating. The committee structure is designed to ensure that individual analyst biases do not drive rating outcomes and that the full collective expertise of the agency is brought to bear on each decision.

Once a rating is assigned, the agency monitors the issuer on an ongoing basis and updates the rating as circumstances change. Rating actions between formal review cycles are communicated through rating watch designations, which indicate that the agency is actively reviewing a rating for possible change, and rating outlook designations, which indicate the agency’s view of the likely direction of a rating over a one to two year horizon. A negative outlook indicates that a downgrade is more likely than not over that horizon. A positive outlook indicates an upgrade is more likely. A stable outlook indicates that the current rating is expected to be maintained.

Investment Grade vs Speculative Grade

The distinction between investment grade and speculative grade ratings is one of the most consequential in all of finance, with far-reaching implications for issuers, investors, and the functioning of capital markets.

Investment grade bonds, those rated BBB- or above by S&P and Fitch or Baa3 or above by Moody’s, are generally considered to have a low probability of default and to be appropriate for conservative investors including pension funds, insurance companies, banks, and other regulated entities. Investment grade issuers have access to the broadest and deepest pool of capital, including markets that are simply unavailable to speculative grade issuers, and they can borrow at lower interest rates reflecting their lower credit risk.

Speculative grade bonds, those rated below BBB- or Baa3, are commonly called high yield bonds in the context of corporate debt markets and junk bonds in popular usage. The term junk bond, while widely used in the press and in casual conversation, carries a pejorative connotation that does not reflect the legitimate role these securities play in the portfolios of investors who are compensated for the additional credit risk they bear through higher yields. High yield bonds offer yields significantly above those available on investment grade bonds, reflecting both the higher probability of default and the lower expected recovery in the event of default.

The yield spread between high yield bonds and investment grade bonds, or between high yield bonds and Treasury securities, is one of the most closely watched indicators of credit market conditions and investor risk appetite. Spreads widen during periods of economic stress and financial market uncertainty as investors demand higher compensation for bearing credit risk, and they tighten during periods of economic optimism and abundant liquidity as investors become more willing to extend credit on favourable terms. The high yield spread is therefore both a reflection of credit market conditions and a predictor of economic conditions, because credit stress often precedes broader economic deterioration.

Rating Agencies and Their Regulatory Role

The role of rating agencies in the regulatory framework adds an additional dimension to their importance beyond their informational function. Numerous regulations, investment guidelines, and contractual arrangements reference credit ratings as criteria for determining eligibility, capital requirements, or permissible investments.

The SEC designates qualifying rating agencies as nationally recognised statistical rating organisations, commonly abbreviated as NRSROs. NRSRO status is a formal regulatory designation that was historically quite limited to the three major agencies but has been expanded to include additional firms. Securities regulations including bank capital adequacy rules, money market fund eligibility standards, and broker-dealer net capital rules have historically referenced NRSRO ratings as eligibility criteria.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 sought to reduce regulatory reliance on credit ratings following the rating agency failures that contributed to the 2008 financial crisis. The act required federal regulators to remove references to credit ratings from their regulations and replace them with alternative standards where feasible, recognising that the incorporation of ratings into regulation had contributed to a mechanistic reliance on ratings that displaced independent credit analysis.

Rating Agency Failures and Criticism

The role of credit rating agencies in the 2008 financial crisis generated intense scrutiny of their methodologies, incentive structures, and conflicts of interest, and fundamentally damaged their credibility in the eyes of many market participants.

During the years preceding the crisis, the major rating agencies assigned investment grade and in many cases the highest AAA ratings to complex structured finance securities including collateralised debt obligations backed by subprime residential mortgage loans. These ratings proved catastrophically wrong when the underlying mortgage collateral deteriorated rapidly as house prices fell and mortgage default rates rose far above historical norms. The structured securities rated AAA suffered massive losses, in some cases losing virtually their entire value, demonstrating that the ratings had provided investors with a deeply misleading assessment of the credit risk they were bearing.

Post-crisis investigations revealed that the failures reflected a combination of flawed analytical models that relied on historical mortgage default data that was not representative of the risk in the new generation of subprime mortgages, competitive pressure among rating agencies to provide the ratings that structured finance arrangers needed to sell their products, and the fundamental conflict of interest inherent in the issuer-pays model, in which the agencies are paid by the issuers whose securities they rate rather than by the investors who rely on those ratings.

The issuer-pays business model creates a structural conflict of interest because the rating agency has a financial incentive to provide ratings that issuers find acceptable enough to pay for, rather than ratings that are purely objective assessments of credit quality. While the major agencies assert that they maintain analytical independence through governance structures and policies that separate the commercial relationship from the analytical process, the conflict is inherent in the business model and cannot be entirely eliminated through procedural safeguards alone.

Sovereign Ratings and Their Implications

Sovereign credit ratings assess the creditworthiness of national governments as borrowers, reflecting both their ability and their willingness to service their debt obligations. Sovereign ratings are among the most consequential in global finance because they affect the borrowing costs of national governments, influence the ratings of banks and corporations headquartered in the rated country through the sovereign ceiling concept, and affect the eligibility of sovereign bonds for inclusion in international bond indices used as benchmarks by global fixed income investors.

The sovereign ceiling concept holds that in most cases, the credit rating of a private entity cannot exceed the credit rating of the sovereign in whose jurisdiction it operates, reflecting the reality that a sovereign government has the power to impose capital controls, freeze foreign currency payments, or take other actions that would prevent private entities from servicing their foreign currency obligations even if those entities are otherwise creditworthy. While rating agencies have moved away from the strict application of the sovereign ceiling in recent years, acknowledging that some private entities may have stronger credit profiles than their sovereign in specific circumstances, the general principle remains influential.

Sovereign rating downgrades can trigger significant market disruptions including forced selling by investors whose mandates restrict holdings below investment grade, sharp increases in government borrowing costs that can become self-reinforcing if they undermine fiscal sustainability, currency depreciation as foreign investors withdraw capital, and broader financial market stress if the sovereign is a systemically important borrower. The European sovereign debt crisis of 2010 through 2012 illustrated these dynamics vividly as rating downgrades of Greece, Portugal, Ireland, Spain, and Italy contributed to sharp increases in their borrowing costs and required extraordinary policy interventions to prevent disorderly defaults.

NRSRO Registration and the Application Record

A credit rating agency that elects to be treated as a nationally recognised statistical rating organisation applies to the Commission for registration, and that application is a substantive disclosure document rather than a request for a title. It must contain the agency’s credit rating performance measurement statistics over short-term, mid-term and long-term periods as applicable, the procedures and methodologies the agency uses in determining credit ratings, the policies and procedures it has adopted to prevent the misuse of material non-public information, its organisational structure, whether it has a code of ethics in effect and if not the reasons why, and any conflict of interest relating to its issuance of credit ratings. The agency must identify the categories of obligor for which it seeks registration and supply, on a confidential basis, a list of the twenty largest issuers and subscribers using its rating services measured by the net revenues received from them in the immediately preceding fiscal year. The Commission grants registration where it finds the statutory requirements satisfied, and must deny it where it finds that the applicant lacks adequate financial and managerial resources to produce credit ratings with integrity consistently and to comply materially with the procedures and methodologies it has disclosed.

The application also rests on the testimony of the ratings’ users. An applicant must furnish written certifications from not fewer than ten qualified institutional buyers, none of them affiliated with the applicant, and not fewer than two certifications for each category of obligor for which registration is sought. Each certification states that the buyer meets the statutory definition of a qualified institutional buyer and that it has used the applicant’s credit ratings for at least the three years immediately preceding the date of the certification in the category or categories concerned. A qualified institutional buyer incurs no liability in any private right of action for an opinion or statement expressed in such a certification, and an agency that had received or been the subject of a qualifying Commission staff no-action letter before the cut-off the statute specifies does not have to provide the certifications at all.

Registration is a continuing record rather than a single event. The agency must promptly amend its application whenever any information or document in it becomes materially inaccurate, except that its performance measurement statistics are brought up to date in the annual submission rather than by prompt amendment, and the user certifications are not amended by that route. Within ninety days after the end of each calendar year the agency must file an amendment to its registration certifying that the information and documents in the application continue to be accurate and listing any material change that occurred during the previous calendar year. On the granting of registration the agency must make the completed application and any amendments publicly available on its website or by comparable readily accessible means, except for the confidential list of its largest issuers and subscribers and the user certifications.

The Limits of Commission Authority Over Ratings

The Commission has exclusive authority to enforce the registration provisions against a nationally recognised statistical rating organisation that issues credit ratings in material contravention of the procedures relating to it that the agency itself has put forward, including the procedures on prevention of the misuse of non-public information and on conflicts of interest that it included in its application or disseminated in its reports. The enforcement hook is therefore departure from the agency’s own stated process rather than disagreement with the rating the process produced. Rules the Commission prescribes for these organisations must be narrowly tailored to the requirements the statute places on them.

Neither the Commission nor any State or political subdivision of a State may regulate the substance of credit ratings or the procedures and methodologies by which a nationally recognised statistical rating organisation determines credit ratings. That limitation affords no defence against an action or proceeding brought by the Commission to enforce the antifraud provisions of the securities laws, so an agency that misrepresents how it reached a rating remains exposed even where the substance of the rating itself lies beyond the reach of regulation.

State law is displaced in one direction only. No law of a State or political subdivision requiring registration, licensing or qualification as a credit rating agency or as a nationally recognised statistical rating organisation applies to such an organisation or to a person employed by or working under the control of one. A State securities commission, or an office performing like functions, nonetheless retains authority to investigate and to bring an enforcement action for fraud or deceit against the organisation or against a person associated with it.

Managing the Issuer-Pays Conflict in Practice

The statute does not abolish the issuer-pays model; it requires that the conflicts the model creates be identified, managed and disclosed. Each nationally recognised statistical rating organisation must establish, maintain and enforce written policies and procedures reasonably designed, taking into consideration the nature of its business and that of its affiliated persons and companies, to address and manage any conflicts of interest that can arise from that business. The Commission is directed to prohibit, or to require the management and disclosure of, conflicts relating to the manner in which the organisation is compensated by the obligor or an affiliate of the obligor for issuing ratings or providing related services, the provision of consulting, advisory or other services to the obligor, business relationships, ownership interests and other financial or personal interests between the organisation or its associated persons and the obligor, and any affiliation with a person that underwrites the securities or money market instruments being rated.

A second requirement separates the commercial side of the business from the analytical one: the rules must prevent the organisation’s sales and marketing considerations from influencing the production of its ratings. Those rules must provide for suspension or revocation of registration where the Commission finds, on the record and after notice and opportunity for a hearing, both that the organisation violated a rule issued under the subsection and that the violation affected a rating. The two findings are cumulative, so a breach of the separation rules that is shown to have left every rating as it stood does not on this ground alone support suspension; the rules must also allow exceptions for small organisations for which separating ratings production from sales and marketing activity is not appropriate.

Certain practices are to be prohibited outright as unfair, coercive or abusive. The organisation may not condition or threaten to condition the issuance of a credit rating on the purchase by the obligor or an affiliate of its other services or products, including pre-rating assessment products, and may not modify or threaten to modify a rating, or otherwise depart from its adopted systematic procedures and methodologies, on the basis of whether the obligor purchases or will purchase the rating or any other product or service. An agency that follows its published methodology to a conclusion the issuer dislikes is doing what the framework contemplates; an agency that moves a rating because further fee-paying work is on offer is engaged in the conduct the framework reaches.

The Look-Back Review When an Analyst Joins an Issuer

Each nationally recognised statistical rating organisation must establish, maintain and enforce policies and procedures reasonably designed to ensure that, where an employee of a person subject to one of its credit ratings, or of the issuer, underwriter or sponsor of a security or money market instrument subject to one of its credit ratings, had been employed by the organisation and participated in any capacity in determining credit ratings for that person or those instruments during the one-year period preceding the date an action was taken with respect to the rating, the organisation conducts a review to determine whether any conflicts of interest of that employee influenced the credit rating, and takes action to revise the rating if appropriate. The review looks backwards at work already done: it asks whether an analyst’s interest in the destination employer bore on a rating the organisation has already published, not whether the analyst behaved properly after leaving.

The window is measured from the rating action, and that is where the requirement is most often misread. Suppose an analyst’s only participation in determining an industrial issuer’s rating was at a rating committee in February, he resigns in June, he becomes that issuer’s treasurer in July, and the organisation affirms the issuer’s rating in March of the following year. From February to the following March is thirteen months, so his participation falls outside the one-year period preceding that action and that action does not trigger the review. Had the organisation instead acted on the rating in the December after his departure, his February participation would fall ten months before the action, inside the one-year period, and the review would be required even though the analyst had by then been gone for six months. The clock therefore runs backwards from each rating action to the participation, and not forwards from the date the analyst changed employers.

A separate obligation runs on a different clock and produces a different outcome. The organisation must report to the Commission any case it knows, or can reasonably be expected to know, in which a person associated with it within the previous five years obtains employment with any obligor, issuer, underwriter or sponsor of a security or money market instrument for which the organisation issued a credit rating during the twelve-month period prior to that employment, where that person was a senior officer of the organisation, participated in any capacity in determining credit ratings for that party, or supervised an employee who did. On receiving such a report the Commission makes the information publicly available. The look-back is a duty to review and where appropriate revise a rating; the employment report is a duty of disclosure about a person’s move, and a single transition can trigger the second without triggering the first.

Internal Controls, the Compliance Officer and the Board

Each nationally recognised statistical rating organisation must establish, maintain, enforce and document an effective internal control structure governing the implementation of and adherence to the policies, procedures and methodologies it uses for determining credit ratings. It must submit to the Commission an annual internal controls report describing the responsibility of its management for establishing and maintaining that structure, assessing the effectiveness of the structure, and carrying the attestation of its chief executive officer or the equivalent individual. The obligation is thus not only to have a control structure but to document it and to have the most senior officer attest annually to an assessment of how well it works.

Each organisation must designate an individual responsible for administering the policies required on the misuse of non-public information and on conflicts of interest and for ensuring compliance with the securities laws and the rules under them. While serving in that capacity the individual may not perform credit ratings, participate in the development of ratings methodologies or models, perform marketing or sales functions, or participate in establishing compensation levels other than for employees working for that individual, and the compensation of the officer may not be linked to the financial performance of the organisation. The officer must establish procedures for the receipt, retention and treatment of complaints about credit ratings, models, methodologies and compliance with the securities laws, including confidential and anonymous complaints from employees and from users of ratings, and must submit an annual report to the organisation describing any material changes to its code of ethics and conflict of interest policies and certifying that the report is accurate and complete.

Each organisation must have a board of directors, at least one half of whose members, and not fewer than two of them, are independent of the organisation, and a portion of the independent members must be drawn from users of ratings. To be independent a member may not, outside his or her capacity as a board or committee member, accept any consulting, advisory or other compensatory fee from the organisation or be a person associated with the organisation or an affiliated company; must be disqualified from any deliberation involving a specific rating in whose outcome he or she has a financial interest; may not have compensation linked to the business performance of the organisation; and serves for a pre-agreed fixed term not exceeding five years that is not renewable. The board oversees the establishment, maintenance and enforcement of the policies for determining credit ratings and of the policies for addressing, managing and disclosing conflicts of interest, the effectiveness of the internal control system over the ratings policies, and the organisation’s compensation and promotion policies and practices.

What an Agency Must Publish About Its Ratings

Each nationally recognised statistical rating organisation must publicly disclose information on the initial credit ratings it determined for each type of obligor, security and money market instrument and on any subsequent changes to those ratings, so that users of ratings can evaluate the accuracy of ratings and compare the performance of ratings across different organisations. The disclosures must be comparable among organisations, clear and informative for investors across a wide range of sophistication, cover a range of years and a variety of types of credit rating including ratings the organisation has withdrawn, be appropriate to the organisation’s business model, and be published free of charge on an easily accessible part of its website and in writing when requested. Each organisation must also include with any credit rating it issues an attestation that no part of the rating was influenced by any other business activity, that the rating was based solely on the merits of the instrument being rated, and that the rating was an independent evaluation of that instrument’s risks and merits.

A form accompanying the publication of each credit rating discloses the assumptions underlying the rating procedures and methodologies, the data relied on to determine the rating and, where applicable, how servicer or remittance reports were used and with what frequency to conduct surveillance of the rating. Its qualitative content includes the potential limitations of the rating and the types of risk the organisation does not comment on, among them liquidity risk and market risk, so a published rating speaks to the credit question it addresses and not to the price volatility of the instrument or to the ease of selling it. Its quantitative content includes the expected probability of default and the expected loss in the event of default, an explanation or measure of the rating’s potential volatility together with the factors that might lead to a change and the magnitude of change a user can expect under different market conditions, and the five assumptions in the ratings process that would have the greatest single impact on the rating if they were proven false or inaccurate, analysed with specific examples.

Methodologies are not frozen, but changing them carries obligations of its own. The procedures and methodologies used must be approved by the organisation’s board or a body performing a similar function and applied in accordance with the organisation’s own policies for developing and modifying them. Where material changes are made, including changes to qualitative models or quantitative inputs, the changes must be applied consistently to all credit ratings to which the changed procedures and methodologies apply, changes to surveillance procedures must be applied to then-current ratings within a reasonable period determined by Commission rule, and the organisation must publicly disclose the reason for the change. Users must be notified of the version of a procedure or methodology used for a particular rating, of a material change when it is made, of the likelihood that the change will alter current ratings, and of a significant error identified in a procedure or model that may result in rating actions.

Structured Finance Ratings and Third-Party Due Diligence

Among the practices to be prohibited as unfair, coercive or abusive is lowering or threatening to lower a credit rating on, or refusing to rate, securities or money market instruments issued by an asset pool or issued as part of an asset-backed or mortgage-backed securities transaction, unless a portion of the assets within that pool or that transaction is also rated by the organisation. The leverage the prohibition removes is the agency’s power to use the rating of the notes to win the rating work on the collateral: an arranger that has had the underlying loans rated by one organisation cannot be told by a second organisation that the notes will be rated lower unless some of those loans are rated by it as well. The prohibition reaches the threat as well as the act, so the conduct does not become permissible merely because no rating was in the end reduced.

Where third-party due diligence services are employed by a nationally recognised statistical rating organisation, by an issuer or by an underwriter, the person providing those services must give written certification, in the format and with the content the Commission establishes, to any organisation that produces a rating to which the services relate, and the organisation must disclose that certification to the public at the time it produces the rating so that the public can judge the adequacy and level of the due diligence provided. The issuer or underwriter of an asset-backed security must itself make publicly available the findings and conclusions of any third-party due diligence report it obtained. The disclosure duties therefore run to the public and not only between the arranger and the agency that rates the deal.

Two of the disclosure items on the form published with a rating go directly to the analytical failures that structured finance ratings produced in the crisis. The qualitative content must include the main assumptions and principles used in constructing the procedures and methodologies, among them the assumptions about the correlation of defaults across the underlying assets that are used in rating structured products, and a statement of the extent to which the data essential to the rating were reliable or limited, including any limits on the scope of the historical data and any limits on access to documents or other information that would have better informed the rating. A user who reads a structured finance rating form can therefore see the correlation assumption and the historical data limitation as stated inputs rather than having to infer them from the rating symbol.

Examination Relevance and Key Takeaways

Bond ratings are tested across the SIE, Series 7, and Series 65 examinations. Candidates must understand the rating scales of the major agencies and the correspondence between them, the distinction between investment grade and speculative grade ratings and the regulatory and market implications of that boundary, the rating process and the factors considered in assigning ratings, the role of rating agencies as NRSROs in the regulatory framework, and the conflicts of interest inherent in the issuer-pays business model.

The core points to retain are these: bond ratings assess the probability that an issuer will meet its debt obligations in full and on time; the major rating agencies are Moody’s, S&P, and Fitch, each using a parallel but differently labelled scale; investment grade ratings begin at BBB- on the S&P and Fitch scales and Baa3 on the Moody’s scale; speculative grade or high yield bonds carry higher default risk and higher yields; the investment grade boundary has enormous practical significance because many institutional investors are restricted from holding below-investment-grade securities; rating agencies are designated as NRSROs by the SEC; and the issuer-pays business model creates an inherent conflict of interest that contributed to rating failures during the 2008 financial crisis.