Credit Rating

An agency's analysis proceeds in two stages. First it forms a view of the borrower itself: the durability of its business (industry cyclicality, competitive position, scale, geographic and product diversification) combined with its financial profile, typically assessed through leverage measured as total debt divided by EBITDA, coverage measured as EBIT or EBITDA divided by interest expense, and cash generation measured as funds from operations relative to debt. That produces a corporate family or issuer credit rating, an opinion on the probability that the borrower fails to honour its obligations.

The second stage assigns ratings to individual instruments. Starting from the issuer level, the agency notches up or down for seniority, security, covenant protection and structural position. A secured first-lien loan with strong collateral may sit above the issuer rating; subordinated, hybrid or holding-company debt sits below it, because expected recovery in a default differs even though the default event itself is shared. Notching widens as credit quality deteriorates, since recovery differences matter more when default becomes plausible.

The letter scale is ordinal, not cardinal: the distance in default risk between AA and A is not the same as between B and CCC, and empirical default rates rise steeply and non-linearly toward the bottom of the scale. Agencies subdivide most grades with plus and minus signs at S&P and Fitch, and with 1, 2, 3 modifiers at Moody's, and attach forward-looking signals: an outlook indicating the likely direction over a medium horizon, and a credit watch or review flagging a near-term decision, often tied to a pending event such as an acquisition.

Ratings move over time, and that migration is itself a source of risk for investors. Transition matrices published by the agencies show the historical probability of an issuer rated in one category ending a year in another, including default. Two regularities matter: higher ratings are more stable than lower ones, and downgrades cluster in recessions. Because agencies aim for ratings that hold through the cycle, changes tend to lag market pricing, and credit spreads frequently reprice a deterioration long before a letter changes.

The investment-grade boundary between BBB- (Baa3) and BB+ (Ba1) is the single most consequential line in credit markets. Bond index construction, insurance and bank regulatory treatment, pension mandates and many collateral frameworks are written around it. An issuer downgraded across that boundary becomes a fallen angel: it can be ejected from investment-grade indices, forcing sales by benchmark-tracking holders regardless of their own credit view, while high-yield buyers absorb the paper at wider spreads. Movement in the other direction produces rising stars.

Contracts amplify the effect. Rating triggers in loan agreements, derivative collateral terms and coupon step-up clauses can raise funding costs or accelerate liquidity needs precisely when a company is weakest, a mechanically procyclical feature. Because agencies are largely paid by issuers and were formally designated as recognised statistical rating organisations for regulatory purposes, the conflict of interest and over-reliance on ratings, especially in structured finance before 2008, remain standing critiques.

A candidate should be able to reconstruct the logic rather than quote the letter. That means computing and interpreting the standard ratios from a set of financial statements, adjusting reported debt for items such as operating leases, pension deficits and off-balance-sheet guarantees, and then placing the result in the context of the industry's tolerance for leverage. Utilities sustain higher debt loads at a given rating than cyclical manufacturers because cash flow volatility, not debt alone, drives default.

Equally important is knowing what a rating excludes. It is an opinion on credit loss, not on liquidity, interest rate risk, currency risk, valuation or price direction, so a highly rated bond can still deliver a poor return. Ratings say nothing about correlation across a portfolio, and structural subordination within a group can make a subsidiary's obligations far safer than a parent's. Practitioners therefore pair agency opinions with market-implied measures derived from spreads and CDS levels, which react faster but embed liquidity and risk premia as well as credit.