Describe the scales used by external rating agencies, how ratings are assigned, and how a rating connects to the chance of default.
The idea
Agencies rank issuers on an ordinal letter scale. Standard and Poor's and Fitch run AAA, AA, A, BBB, BB, B, CCC, CC, C and D, with plus and minus modifiers. Moody's runs Aaa, Aa, A, Baa, Ba, B, Caa, Ca and C, with numeric modifiers 1, 2 and 3, where 1 is the best. BBB− or Baa3 and above is investment grade, and anything lower is speculative grade. Analysts combine quantitative work such as leverage and coverage ratios with qualitative judgement about management, industry position and funding, and a committee votes on the result. The issuer usually pays the fee. Each grade is linked to default probability through long-run historical default rates, which rise steeply as the rating falls. Those rates are averages over many cycles, not guarantees for any one year. For low grades, the annual default probability conditional on survival tends to fall with horizon, because survivors improve.
A practice question
On the standard agency scales, which pair of ratings marks the lowest investment-grade category?
- BB+ (S&P and Fitch) and Ba1 (Moody's)Why not: These are the first speculative-grade notches, one step below the investment-grade boundary.
- BBB- (S&P and Fitch) and Baa3 (Moody's) - correct
- BBB+ (S&P and Fitch) and Baa1 (Moody's)Why not: These are the top of the BBB/Baa band, not the lowest investment-grade rating.
- A- (S&P and Fitch) and A3 (Moody's)Why not: Treats the bottom of the A band as the cutoff; investment grade extends down through the BBB/Baa band.
Investment grade runs from AAA/Aaa down to BBB-/Baa3. Anything at BB+/Ba1 or lower is speculative grade.
A harder one
A portfolio holds 200 loans rated BBB, 200 rated BB and 100 rated B. Historical one-year default rates are 0.2% for BBB, 0.9% for BB and 4.5% for B. Expected number of defaults over one year is closest to:
- 9.3Why not: Applies the simple average of the three default rates (1.87%) to all 500 loans instead of weighting by the number in each grade.
- 6.7 - correct
- 2.2Why not: Leaves out the 100 B-rated loans, which contribute 4.5 of the expected defaults.
- 67Why not: Moves the decimal place: 0.4 + 1.8 + 4.5 = 6.7 defaults, not 67.
Expected defaults = 200 x 0.2% + 200 x 0.9% + 100 x 4.5% = 0.4 + 1.8 + 4.5 = 6.7. Each rating grade has its own historical default rate, so weight by the count in each grade.
The hardest tier
Illustrative cumulative default probabilities from a rating study are: A-rated: 0.10% at one year, 0.30% at two years, 0.60% at three years. B-rated: 4.00%, 8.00% and 11.40% respectively. Which conclusion about the conditional (marginal) annual default probability is supported by these figures?
- For A it rises (0.10%, 0.20%, 0.30%), but for B it peaks in year 2 and then falls (4.00%, 4.17%, 3.70%). - correct
- For both ratings the conditional probability rises each year, because credit quality always deteriorates over time.Why not: Ignores that B-rated survivors can improve; the B conditional probability in year 3 (3.70%) is below year 2 (4.17%).
- For both ratings the conditional probability is constant, because cumulative probabilities rise roughly linearly.Why not: Reads rising cumulative figures as constant hazard; dividing marginal default by survival shows the A path rising and the B path falling.
- For A the conditional probability falls and for B it rises, because higher-rated issuers revert to the mean.Why not: Reverses the pattern: strong issuers can only drift down and weak survivors tend to improve, not the other way round.
Conditional year 3 for A = (0.60 - 0.30) / (100 - 0.30) = 0.30%, rising from 0.10% and 0.20%. For B: year 2 = 4.00/96 = 4.17%, year 3 = 3.40/92 = 3.70%. Survivors among weak credits are those that improved.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in External and Internal Credit Ratings
- Distinguish default probabilities that are conditional from those that are unconditional, defining each.
- Define the hazard rate, then apply it to find the unconditional probability that a credit asset defaults.
- Define the recovery rate and, with it, compute the loan's expected loss.
- Contrast ratings built on a point-in-time basis with those built through the cycle, and explain each.
- Outline the options that can be used in place of the credit ratings issued by rating agencies.
- Weigh internal ratings against external ones, noting the strengths of each.
- Describe a rating transition matrix, calculate with it, interpret it, and explain what it is used for.
- Outline how credit default swap spreads, bond prices and stock prices tend to move when a credit rating is upgraded or downgraded.
- Explain where credit ratings have failed in the past and what difficulties arise when they are relied on for investment decisions.