Fixed Income 101: Credit ratings

The primary risk in a fixed income portfolio is credit risk – the risk that a bond issuer will fail to make payments (or “default”) on its debt.

Credit ratings, which are produced by specialist rating agencies, are one well known gauge of creditworthiness. Borrowers are assigned a rating based on the agency’s view of their financial health and the likelihood that bondholders will receive their principal and coupon repayments on time and in full.

Historically, higher rated bonds have experienced lower default rates than lower rated bonds. As a result, lower rated bonds generally offer higher yields to compensate investors for their higher credit risk.

While we believe an active manager should never rely on ratings alone in their credit analysis of a bond issuer, they can be a useful tool for assessing relative pricing across the market and for communicating levels of risk to investors.

Investment grade and high yield

Rating agencies are at pains to stress that their ratings are opinions, not guarantees. However, they do offer a standardised framework for measuring credit risk, and the ubiquity of ratings across the bond market means they are commonly used to place limits on investment strategies, with documentation often stating that a fund cannot hold assets below a certain rating level, for example.

The credit rating market (bond issuers pay agencies for ratings) is dominated by the so-called big three – Moody’s, S&P and Fitch. While there are small differences, the rating scale essentially runs from AAA down to CCC, with notches below this indicating severe stress and imminent default (see Exhibit 1).

The AAA to BBB- bracket is referred to as investment grade (IG), while anything below this threshold is described as high yield (HY) or more colloquially (and somewhat harshly) as “junk” bonds.¹

As Exhibit 2 shows, defaults in corporate bonds rated AAA, AA and A have historically been extremely low. Historical default rates begin to pick up as you down the credit spectrum, with notable spikes at times of severe economic stress such as 2009 and 2020.

How are ratings calculated?

Agencies assign ratings based on a range of quantitative and qualitative factors, and they are required by regulators to publish their methodologies.

The quantitative factors include financial metrics such as leverage, cashflow, liquidity and profitability. However, qualitative factors such as industry outlook, company leadership and the strength of the business model, alongside broader macro and geopolitical considerations, can be equally important.

Agencies regularly review issuers’ credit ratings and can also upgrade or downgrade them in response to new information, such as a macroeconomic shock to a company’s domestic economy or if they expect more challenging conditions for a particular industry due to political or regulatory change, for example.

Importantly, not every bond from the same issuer will carry identical ratings. A bank’s Tier 2 and Additional Tier 1 (AT1) bonds will have lower ratings than its senior unsecured bonds, for example, because they are subordinated in the bank’s capital structure and thus carry greater credit risk. For corporates, there is a similar dynamic between holding company (HoldCo) and operating company (OpCo) bonds because OpCo debt is senior secured and its holders rank above HoldCo creditors in the event of bankruptcy or restructuring.

Credit ratings can move markets

Credit ratings are widely used to specify the “quality” of assets a fund is permitted to hold. Many will be restricted to IG bonds, for example, or have a maximum percentage allocation to assets rated below a certain level, which offers clarity and comfort to end investors.

This means rating agencies’ views directly influence how billions of dollars are invested globally, with potentially big implications for issuers’ borrowing costs.

An IG rating gives a company access to a large pool of capital that is barred from participating in HY. Companies planning to issue bonds for the first time will often make structural or strategic changes to achieve a higher credit rating and by extension a lower cost of debt.

Rating upgrades and downgrades, meanwhile, can lead to large moves in bond prices, particularly where a HY issuer is upgraded to IG (a “rising star”) or an IG issuer is downgraded to HY (a “fallen angel”). Crossing the boundary between BBB- and BB+ in either direction typically triggers a big price swing in an issuer’s bonds, with IG-only funds becoming forced sellers of fallen angels and passive funds becoming forced buyers of rising stars once they are added to various IG indices.

The takeaway here should not be that anything without an IG rating is inherently risky. Indeed, looking back at the S&P data in Exhibit 2, the annual default rate on BB rated corporate bonds globally has been below 1% every year since 2003. Some HY rated companies may be using leverage to fund investment and future growth, for example, while others may be well-run businesses in capital-intensive industries where the operating environment tends to be more volatile, such as energy or commodities.

How do active managers use credit ratings?

For active fixed income managers, credit ratings are no substitute for individual credit analysis and regular engagement with company management teams. 

Rating changes often lag the market, particularly in response to negative news around a company, and an issuer’s bond prices can fall dramatically before its credit rating is downgraded. 

Therefore, active managers generally do not rely on credit ratings alone, but they can be a useful complement to broader credit research. Ratings can help identify potential areas of relative value, for example, if an issuer’s bonds are trading at a higher yield than identically rated peers. Active managers can also look for opportunities where they disagree with the rating agencies’ view, avoiding bonds that they expect to fall in price because the rating is too optimistic or investing in lower rated bonds where they think the yield is overcompensating investors for the credit risk.