Ratings and agencies

~8 min read

Interview occasional

Why it matters

Ratings are the shorthand the whole market uses to sort credits before anyone reads a single covenant — they gate what many funds are even allowed to buy, and they’re baked into regulatory capital rules for banks and insurers. Knowing what a rating is (and isn’t) protects you from the classic interview trap of treating a letter grade as a precise probability.

Core concepts

The big three: Moody’s, S&P, Fitch. Moody’s uses Aaa/Aa/A/Baa/Ba/B/Caa/Ca/C; S&P and Fitch use AAA/AA/A/BBB/BB/B/CCC/CC/C, each with +/− or numeric modifiers (Aa1/Aa2/Aa3 ≈ AA+/AA/AA−). The letter is an ordinal ranking of relative credit risk, not a calibrated default probability — agencies are explicit that ratings measure relative, not absolute, risk.
Investment grade vs. speculative grade is the single most consequential line in the market. BBB−/Baa3 or better is investment grade (IG); BB+/Ba1 or below is high yield (HY) / speculative grade. Many pension funds, insurers, and money-market-adjacent mandates are contractually or regulatorily restricted to IG only — a downgrade across that line (“fallen angel”) forces indiscriminate selling regardless of fundamental view. See IG vs. HY.
What agencies actually assess. Business risk (industry cyclicality, competitive position, scale), financial risk (leverage ratios like Debt/EBITDA, interest coverage, FFO/Debt), management/governance quality, and increasingly explicit country/industry ceilings. Methodology publications for each sector are public and are exactly what a credit analyst benchmarks against.
Issuer rating vs. issue rating. A corporate has a single issuer (family) rating, but individual bonds can be rated differently based on seniority and structural position — a senior secured note can sit one or more notches above the issuer rating, a subordinated note one or more notches below, reflecting expected recovery in default (see Seniority & capital structure).
Watchlist and outlook are the leading indicators. A “negative outlook” or “on review for downgrade” precedes many actual rating actions by months and often moves spreads before the letter grade changes — the market reacts to the direction of travel, not just the current notch.
Ratings are lagging, and the agencies know it. Ratings react to public information and agency analyst judgment; markets and CDS spreads frequently move ahead of a rating change. The 2008 crisis and CDO downgrades are the canonical cautionary tale about over-relying on ratings as a risk-management substitute rather than an input.
Split ratings and shadow/synthetic ratings. When agencies disagree (a “split-rated” credit), desks often use the average or the lower of the two as the working assumption; for unrated or thinly-rated issuers, analysts build a synthetic rating from the same financial-ratio framework the agencies publish.

Mental model

  Issuer (corporate family) rating
        |
        +-- Senior secured notes   ->  rated ABOVE issuer rating (better recovery)
        +-- Senior unsecured notes ->  rated AT/near issuer rating
        +-- Subordinated notes     ->  rated BELOW issuer rating (worse recovery)

  Investment grade  |  Speculative grade (high yield)
  AAA / Aaa  ......  BBB- / Baa3   |   BB+ / Ba1  ......  D
                     ^
              the line that triggers forced selling on a downgrade ("fallen angel")

Interview questions

What does a “BBB” rating actually tell you, and what does it not tell you? Answer: It tells you S&P/Fitch’s ordinal, relative assessment that this issuer’s credit risk sits in the lowest investment-grade tier, based on business risk, leverage, and coverage metrics. It does not give you a precise, calibrated default probability, a market price, or a guarantee that the rating is current — outlooks and watchlist status carry the forward-looking signal.
Why can a single corporate have bonds with different ratings from the same agency? Answer: Because notching reflects expected recovery given the bond’s position in the capital structure. A senior secured tranche recovers more in default than a subordinated tranche of the same issuer, so agencies notch the issue rating up or down from the issuer/family rating accordingly.
A BBB− issuer gets downgraded one notch to BB+. Why does this matter more than a BBB to BBB− downgrade of the same size? Answer: It crosses the investment-grade/high-yield line. Many IG-only mandates are forced to sell regardless of their fundamental credit view (“fallen angel” selling), which can push spreads wider than the fundamental deterioration alone would justify — a technical, forced-flow effect layered on top of the credit story.
Ratings agencies were widely criticized after 2008. What’s the structural critique, beyond “they got it wrong”? Answer: The issuer-pays model creates a potential conflict of interest (agencies are paid by the entities they rate); ratings are inherently backward/slow-moving relative to market-implied risk (CDS spreads); and for structured products specifically, rating models underestimated correlated default risk across underlying assets. The lesson for a credit analyst: use ratings as one input, cross-check against spread-implied and fundamental views, never as a sole risk gate.
How would you build a “shadow rating” for an unrated private credit? Answer: Apply the same public methodology frameworks the agencies publish for that industry — benchmark leverage (Debt/EBITDA), coverage (EBITDA/Interest, FFO/Debt), scale, margin stability, and business-risk qualitative factors against rated peers, then map the resulting profile to the nearest rating category as a working proxy.

Watch

Session 11: Costs of Debt and Capital — Prof. Aswath Damodaran (NYU Stern). Walks through how ratings map to synthetic default spreads and feed into the cost of debt.