What do credit ratings like AAA, BBB, BB actually mean, and how do they affect bond yields?

Credit ratings assess the probability of default — the likelihood that an issuer will fail to make timely interest or principal payments. The three major agencies (Standard & Poor's, Moody's, and Fitch) use similar but slightly different scales.

Rating Scale Overview:

The BBB/BB boundary is critical — it separates investment grade from speculative grade ("junk" bonds). This matters because:

1. Many institutional investors (pension funds, insurance companies) are restricted to investment-grade bonds only
2. A downgrade from BBB to BB (a "fallen angel") triggers forced selling, causing sharp price drops
3. Credit spreads widen significantly at this boundary

Yield Impact:

Higher risk = higher required yield. The extra yield over a risk-free government bond is the credit spread.

Rating agencies consider:

• Business risk (industry, competitive position, management)
• Financial risk (leverage, coverage ratios, cash flow)
• Country and regulatory environment
• Qualitative factors (governance, strategy)

Exam tip: Ratings are lagging indicators — markets often reprice bonds before the agency acts. Also remember that ratings address default risk, not interest rate risk or liquidity risk.

Practice credit analysis questions in our CFA Level I question bank.