Lesson 4 of 7
What a credit rating measures
A credit rating is an opinion on default risk, paid for by the company rated. The line between investment grade and high yield forces some holders to sell.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A credit rating is one agency's opinion on the risk that a company does not pay its debt in full and on time, nothing more.
- The company being rated usually pays the agency, a conflict SEC rules require agencies to disclose and manage, not remove.
- Crossing from investment grade into high yield forces some funds to sell by mandate, regardless of what they think the bond is worth.
A credit rating is an agency's ranking of credit risk: the chance of default and, on some scales, how much is lost if it happens. It says nothing about whether the borrower's stock is cheap, whether its business is a good one, or where its price is headed.
One company's rating path, two downgrades
- 2021ARated single-A: comfortably investment grade.
- 2023BBBCut three notches to BBB, the lowest investment-grade category (BBB+ to BBB−).
- 2025BBCut again to BB, below the investment-grade line.
An opinion, not a guarantee
The three registered agencies that dominate US ratings, Moody's, S&P and Fitch, each publish a scale running from the safest borrowers down to default. A rating is the agency's own view of default risk, built from the company's financial statements, its industry, and its own judgement. It carries no promise: agencies have both missed defaults and downgraded companies that went on to pay in full.
The issuer usually pays
Under the model that has dominated the US market for decades, the company issuing the bond pays the agency to rate it, not the investor buying the bond. The Credit Rating Agency Reform Act of 2006 set up SEC registration and oversight of rating agencies (NRSROs). Under it, an agency must disclose and manage conflicts of interest such as issuer payment. A rating is one input, not a verdict.
Investment grade is a line, not a spectrum
Ratings from AAA down to BBB− (or the equivalent on another agency's scale) are called investment grade. Everything below that, BB+ and lower, is called high yield or speculative grade. The line matters more than any single notch around it, because many pension funds, insurance mandates and bond funds are required by their own rules to hold only investment-grade debt. A bond downgraded across that one line, from BBB− to BB+, is called a fallen angel. It can face forced selling from holders who have no view on the company at all, only a mandate they must follow.
What a downgrade costs the shareholder
A downgrade is not only a label change. Refinancing existing debt or issuing new debt costs more once the rating falls. Some loan agreements carry a pricing grid that steps the interest rate up automatically at a lower rating. And some contracts require the company to post collateral once its rating drops, a rating trigger that can strain cash at the worst time.
Check yourself
Who typically pays the agency that rates a company's bond?
- The investor who buys the bond
- The company issuing the bond
- The SEC
Show the answer
Answer: B.
In the dominant US model the issuer pays for its own rating. SEC rules treat that as a conflict agencies must disclose and manage.A bond is downgraded from BBB− to BB+. What just happened?
- Nothing changed in what kind of holders can own it
- It crossed from investment grade into high yield, and some mandates now require holders to sell it
- The company is now in default
Show the answer
Answer: B.
BBB− is the lowest investment-grade tier and BB+ is the highest high-yield tier. Crossing that one line can force sales that have nothing to do with the company's outlook.What does a credit rating actually measure?
- Whether the company's stock price is too low
- The agency's opinion of the risk that the company does not pay its debt in full and on time
- The company's return on equity
Show the answer
Answer: B.
A rating is an opinion on default risk alone. It is not a judgement on the business or its stock price.Sources
- Credit Rating Agency Reform Act of 2006 and the SEC Office of Credit Ratings: registered rating agencies (NRSROs) and their published rating scales.
What this leaves out
- The rating path and the before-and-after table are illustrative shapes, not one company's filed history.
- Rating scales, notch names and which mandates require investment grade all vary by agency and by fund; this lesson gives the general pattern, not any one document's exact wording.
- Nothing here rates any real company's debt or says what its bonds are worth. Nothing here is advice about any security.