How Credit Ratings Work
Credit ratings are assessments by agencies like S&P, Moody's, and Fitch that evaluate a bond issuer's likelihood of repaying its debt. S&P's scale runs from AAA (highest quality) through AA, A, BBB (investment grade) down to BB, B, CCC (speculative grade, or junk). A single downgrade can increase an issuer's borrowing costs by 0.3-1.0%, as investors demand higher yields to compensate for increased risk.
Ratings and Yield Spreads
Lower ratings mean higher default risk, so investors require higher yields. The spread between AAA and BBB corporate bonds is typically 0.8-1.2%, widening to 2-3% for BB-rated bonds. These spreads fluctuate with economic conditions, expanding sharply during recessions as default fears rise. Credit spreads serve as a real-time barometer of market risk sentiment.
Limitations of Credit Ratings
The 2008 financial crisis exposed serious flaws in the rating system when AAA-rated mortgage-backed securities defaulted en masse. Ratings are opinions based on historical data and projections, not guarantees. The issuer-pays model creates potential conflicts of interest since the entities being rated also pay for the service. Use ratings as one input among many, and always review financial statements independently.