Credit ratings and credit spreads

In 2006 and 2007, thousands of mortgage securities were rated AAA, the same grade as the safest governments. Within two years many had been cut to junk and investors had lost heavily. What does a rating actually promise, and what does the market's own price for risk say?

Not every borrower pays. The risk that it does not is credit risk. Investors judge it in two ways: by asking a specialist for an opinion (a rating), and by watching how much extra yield the market demands (a spread).

Credit ratings

A credit ratingAn agency's opinion of how likely a borrower is to pay its debts in full and on time, shown as a letter grade. is a letter grade from a rating agencyA firm that publishes credit ratings, such as S&P Global Ratings, Moody's or Fitch.. Three agencies dominate: S&P Global Ratings, Moody's and Fitch. They study the issuer's finances, its industry and the bond's terms, and publish a grade that they review over time. Usually the issuer pays for the rating, which creates a conflict of interest that regulators now watch closely.

The scale runs from AAA down to D. The key line sits between BBB− and BB+ (Baa3 and Ba1 at Moody's). Above it is investment gradeRated BBB− (Moody's Baa3) or higher: judged to have an adequate or better capacity to pay.; below it is high yieldRated BB+ (Moody's Ba1) or lower. Also called speculative grade or junk., also called junk. Many funds may only hold investment-grade bonds, so crossing the line matters. A bond cut below it is a fallen angelA bond cut from investment grade to high yield., and forced selling can push its price down sharply.

Default rates rise steeply as you go down the scale. AAA and AA issuers almost never default within a year; for CCC issuers, default is common. A rating is a ranking of risk, not a precise probability.

Credit spreads

The market gives its own verdict every day. Take a company bond and a government bond with the same maturity. The company bond yields more, because its holders might not be paid. The difference is the credit spreadThe extra yield a bond pays over a safe benchmark of the same maturity, usually a government bond.. Spreads are quoted in basis pointsOne hundredth of a percentage point: 0.01%. 100 basis points make 1%. (bp): 1.5% is 150 bp.

A spread pays the investor for three things:

Spreads through the cycle. In calm times spreads are narrow. In a recession or a financial panic they widen fast: defaults look more likely, investors want more for bearing risk, and dealers are less willing to buy bonds (L1.4.10). Spreads often move before ratings do, because prices react in seconds and agencies take weeks.

The spread is a difference of two yields to maturity (L1.4.04), converted to basis points:

Expected loss uses two numbers from later credit lessons: the probability of default PDProbability of default: the chance the borrower fails to pay, usually over one year. and the loss given default LGDLoss given default: the share of the money owed that is lost if the borrower defaults. One minus the recovery rate.:

Whatever is left is the premium for risk and illiquidity:

This is a rough split for intuition. Measuring each premium properly needs models covered in Level 2.

Start with the worked example: 5.6% against 4.1%, with a 1% default probability and 60% loss given default. Then raise the default probability to 3% and see what happens to the premium.

A 5-year bond from a BBB-rated company yields 5.6%. The 5-year government bond yields 4.1%. Both yields are annual. Try each step first.

Ratings are built into the rules. Under the Basel standardised approach, the capital a bank holds against a rated corporate bond depends on its rating (L4.2). For insurers, the Solvency II spread risk module charges more for lower-rated and longer bonds (L4.6).

The agencies themselves are regulated. After 2008, the EU introduced its Credit Rating Agencies Regulation, and in the US, agencies register with the SEC as nationally recognised statistical rating organisations. The aim is to manage conflicts of interest and make rating methods more open.

• A credit rating is an agency's opinion of default risk, from AAA (Aaa) down to D.
• BBB− / Baa3 and above is investment grade; BB+ / Ba1 and below is high yield.
• The credit spread is the extra yield over a government bond of the same maturity, quoted in basis points.
• A spread pays for expected loss (PD × LGD), a risk premium and a liquidity premium. Expected loss is usually only part of it.
• Spreads widen in stress, often before ratings change.

Credit rating

An agency's opinion of how likely a borrower is to pay its debts in full and on time, shown as a letter grade.

Rating agency

A firm that publishes credit ratings, such as S&P Global Ratings, Moody's or Fitch.

Investment grade

Rated BBB− (Moody's Baa3) or higher: judged to have an adequate or better capacity to pay.

High yield

Rated BB+ (Moody's Ba1) or lower. Also called speculative grade or junk.

Fallen angel

A bond cut from investment grade to high yield.

Basis point

One hundredth of a percentage point: 0.01%. 100 basis points make 1%.

Credit spread

The extra yield a bond pays over a safe benchmark of the same maturity, usually a government bond.

PD

Probability of default: the chance the borrower fails to pay, usually over one year.

LGD

Loss given default: the share of the money owed that is lost if the borrower defaults. One minus the recovery rate.

Expected loss

The average loss to expect over a year: probability of default times loss given default.

Liquidity premium

The extra yield investors want for holding a bond that may be hard to sell quickly at a fair price.