Investor Corner/The asset classes/Debt Concepts
2.2.7 Credit Ratings
Credit ratings are independent grades, such as AAA, AA and BBB, that estimate a borrower's likelihood of default. Lower ratings signal higher risk and typically come with higher yields to compensate.
Who assigns them and why
Rating agencies analyse a borrower's finances, industry position and repayment history, and assign a letter grade meant to summarise their assessment of default risk in a form investors can compare quickly across very different borrowers. AAA generally represents the highest level of safety, with risk increasing as the rating scale moves down through AA, A, BBB, and further.
The line that matters most
The distinction between investment grade, generally BBB and above, and below investment grade is one of the more important lines on the rating scale. Many institutional investors and some mutual fund categories are restricted from holding anything below investment grade, which affects how easily a downgraded bond can be resold and can amplify price moves when a downgrade actually happens.
Using ratings sensibly
Credit ratings are a genuinely useful starting filter, but they are not infallible, and rating agencies have been wrong before, sometimes significantly so during periods of financial stress. Ratings are best treated as one input into a credit decision, combined with diversification across issuers, rather than relied upon as the sole basis for taking on credit risk.
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