Credit spreads and credit ratings are two different lenses on the same fundamental question: how risky is this bond? Ratings are agencies' opinions; spreads are markets' opinions. The two usually agree, but the disagreements are where the alpha (and the embarrassments) live.
Spread decomposition
A credit spread can be decomposed into three components: expected loss (probability of default times loss given default times exposure at default), a risk premium for unexpected loss and ratings volatility, and a liquidity premium. For an IG bond, expected loss is typically a small share of the spread — most of the compensation is risk and liquidity premium. For deep distressed paper trading at 30 cents, expected loss can be 60-80% of the spread.
The three major rating agencies
- Moody's: scale Aaa through C. Splits each whole-letter rating into three sub-grades (Aa1, Aa2, Aa3).
- S&P Global Ratings: scale AAA through D. Sub-grades with + and - modifiers (AA+, AA, AA-).
- Fitch Ratings: identical scale and modifiers to S&P.
How agencies arrive at a rating
Agency analysts review the issuer's financial statements, business model, industry, competitive position, capital structure, and management. They build their own forward forecasts, apply scenario analysis, and run their internal scorecards. The final rating goes through a committee review where the lead analyst defends the proposal against challenge. Once published, ratings are monitored continuously, with formal reviews at least annually and ad-hoc reviews triggered by material events.
Issuer ratings versus issue ratings
An issuer rating reflects the overall credit standing of a company. An issue rating reflects the specific bond's risk, including seniority, security, and any guarantees. A senior secured bond often rates one notch above the issuer; a subordinated bond often rates one or two notches below. For a complex capital structure, each instrument has its own rating.
The migration matrix
Rating agencies publish annual transition matrices showing the historical probability of any rating migrating to any other rating (including default) over various time horizons. The matrix is the empirical foundation of structured credit modelling and is what every credit portfolio manager uses to estimate downgrade risk and the contribution of credit migration to total return.
The fallen-angel trade
When an issuer falls from IG to HY, forced selling by IG-mandated funds can push the bond's price below intrinsic value. Specialist HY funds buy the panic. Historically, fallen-angel returns over the 12 months following downgrade have outperformed both broad IG and broad HY indices. This is one of the most reliable factor trades in credit.
When markets and ratings disagree
Bonds occasionally trade at spreads inconsistent with their rating: a BBB bond trading at a BB-implied spread, or vice versa. The disagreement signals either that the market sees something the agencies have missed (almost always the leading indicator) or that there is a temporary technical dislocation. The most famous failure of the agency model was the AAA tranches of subprime mortgage securitisations that traded as risky paper from 2007 onward while still rated AAA. The market was right; the agencies eventually caught up.
Sovereign rating sensitivity
Most credit-rating agencies cap corporate ratings near the sovereign rating of the issuer's domicile. A company in a B-rated country rarely gets a BBB rating, regardless of its financials. This 'sovereign ceiling' explains many of the AAA-to-Aa3 rating moves in emerging-market corporates that followed sovereign downgrades during the 2022-24 cycle.
Exercise
Why might a BBB corporate bond trade at a 600 basis-point credit spread when historical loss data suggests its expected loss is only 80 bps?