How Credit Ratings Are Assigned at Issuance

Rating agencies predicted the 2008 financial crisis with stunning inaccuracy: over 36,000 structured finance tranches were downgraded in 2007-2008, with nearly one-third holding AAA ratings that proved worthless. More than $520 billion in write-downs followed. Today, ratings remain the market's primary credit language, but the lag between deteriorating fundamentals and rating action means ratings tell you where an issuer was, not necessarily where it's going. The practical approach: use ratings as a starting vocabulary, then verify with your own analysis.

What Rating Agencies Actually Measure (and What They Miss)

Credit ratings represent an agency's opinion on relative expected loss. The key word is "relative"—a BBB bond isn't predicted to lose X% of principal. It's predicted to experience losses similar to historical BBB defaults. Moody's defines this as expected default probability multiplied by loss severity in default.

The inputs fall into two categories:

Quantitative factors (typically 50-60% of the score):

• Leverage: Debt/EBITDA, Debt/Book Capitalization
• Coverage: EBITDA/Interest, (EBITDA-CAPEX)/Interest
• Cash flow: (CFO-Dividends)/Debt, Free Cash Flow/Debt

Qualitative factors (typically 40-50% of the score):

• Industry risk and competitive position
• Management track record and financial policy
• Country and regulatory risk
• Business diversification

The point is: ratings aren't purely mechanical outputs. Two companies with identical leverage ratios can receive different ratings if one operates in a stable industry (utilities) versus a cyclical one (auto parts). The qualitative overlay matters—and it's where judgment (and error) creeps in.

The Rating Scale (From Bulletproof to Junk)

Investment grade issuers can access commercial paper markets, pension fund portfolios, and bank lines at favorable rates. Speculative grade (high yield) issuers pay significantly higher spreads and face institutional constraints.

Investment Grade:

Speculative Grade (High Yield):

The critical boundary: BBB-/Baa3 is the lowest investment grade rating. One notch lower (BB+/Ba1) triggers forced selling by many institutional mandates. This cliff creates real price impact—bonds downgraded from BBB- to BB+ (so-called "fallen angels") often gap down 5-10% or more as mandated sellers exit.

Leverage Thresholds (The Math That Matters)

While agencies emphasize there's no fixed ratio-to-rating mapping (the relationship shifts with economic cycles and sector norms), practical thresholds exist:

Debt/EBITDA by rating tier (industrial corporates):

• Investment grade: Typically 2.0x-3.5x
• BB range: Typically 3.5x-5.0x
• B range: Typically 5.0x-6.5x or higher

Interest coverage (EBITDA/Interest):

• Investment grade: Generally >4.0x
• Speculative grade: 2.0x-4.0x
• Distressed territory: <2.0x

Why this matters: every 1x increase in Debt/EBITDA above 4x correlates with 50-100 basis points in wider credit spreads. A company levering from 4x to 6x might see its borrowing cost jump 100-200 bps—real money on a $500 million bond issue.

The durable lesson: ratios provide a starting point for positioning an issuer, but the qualitative factors (industry stability, asset coverage, management credibility) determine whether a 4x leverage company gets BBB or BB.

The Rating Process at Issuance (What Actually Happens)

When a company plans to issue bonds, the rating process typically unfolds over 4-8 weeks:

Phase 1: Engagement The issuer (who pays for the rating—more on this conflict later) provides financial statements, projections, and management presentations. The analyst team reviews public filings and industry comparables.

Phase 2: Management Meeting Rating analysts meet with CFO/Treasurer to discuss business strategy, capital allocation, and how proceeds will be used. This is where qualitative factors get assessed—and where management can make their case for favorable treatment.

Phase 3: Committee Decision A rating committee (not individual analysts) votes on the rating. This provides some protection against individual bias, but committees also tend toward consensus and status quo.

Phase 4: Publication The rating is published with a rationale document explaining key factors. For new issuances, the rating typically arrives 1-2 weeks before pricing to give investors time to evaluate.

The practical point: ratings reflect a snapshot at issuance. Post-issuance surveillance exists, but the bar for changing a rating is high—agencies prefer stability, which creates the lag problem.

Rating Limitations (Why You Can't Stop at the Letter)

Limitation #1: The lag problem Research shows ratings adjust slowly compared to market prices. Distance-to-Default metrics (derived from equity volatility and capital structure) can predict downgrades 6-12 months before the rating action occurs. By the time an agency downgrades, the bond market has often already repriced.

Limitation #2: The issuer-pays conflict Since the 1970s, issuers have paid for ratings (previously, investors subscribed). This creates an inherent tension: agencies need issuer business, and issuers want higher ratings. The 2008 crisis made this painfully visible—agencies rated $3+ trillion in subprime securities investment grade, collecting substantial fees while those securities imploded.

Post-crisis reforms (Dodd-Frank, SEC Rule 17g-8) added disclosure requirements and conflict-of-interest policies, but the fundamental model remains. The SEC charged S&P with conflict-of-interest violations as recently as 2022.

Limitation #3: Ratings measure relative, not absolute, risk A BBB rating doesn't guarantee anything. Historical data shows:

• Investment grade (AAA-BBB): 0.82% cumulative default probability over 5 years
• BBB specifically: 1.60% over 5 years
• B rated: 9.27% over 5 years

Small percentages, but on a 100-bond portfolio, 1-2 defaults in investment grade and 9-10 defaults in single-B paper represents real losses.

Limitation #4: Split ratings create uncertainty 17% of U.S. industrial bonds carry different letter ratings from Moody's and S&P (Livingston & Zhou, 2010). At the notch level, nearly half have split ratings. Split-rated bonds show 3-6% higher probability of rating changes within one year—they're signaling disagreement about credit quality.

Detection Signals (When Ratings Might Mislead You)

You're relying too heavily on ratings if:

• Your credit analysis stops at "it's investment grade" (that phrase covers everything from Aaa to Baa3—a wide quality range)
• You can't identify the issuer's leverage ratio without looking it up (ratings lag, ratios don't)
• You're surprised by rating changes (the bond market usually knows first)
• You treat all BBB bonds as equivalent (the BBB bucket contains both solid credits and "fallen angel candidates")
• You ignore split ratings as noise (they're often early warning signals)

Using Ratings Correctly (The Practitioner Approach)

Ratings work best as a screening tool and common vocabulary, not as investment conclusions.

Essential (high ROI):

• Use ratings to filter the universe (e.g., "only investment grade" or "BB and better")
• Check for split ratings—if Moody's says BB and S&P says BBB-, dig deeper
• Know the cliff: BBB-/Baa3 holders face forced-selling risk on downgrade
• Verify leverage ratios yourself—don't assume the rating reflects current reality

High-impact (for active credit investors):

• Monitor credit spreads for rating-versus-market divergence
• Track Distance-to-Default or CDS spreads as leading indicators
• Review rating agency reports for qualitative factors you might miss

Advanced (for institutional portfolios):

• Build internal credit scores to complement agency ratings
• Model downgrade scenarios for BBB holdings (what if 10% become fallen angels?)
• Diversify rating agency exposure—don't rely solely on one agency's view

Next Step (Put This Into Practice)

Pick one bond or bond fund in your portfolio and verify the rating against current fundamentals:

How to do it:

1. Find the current rating (Bloomberg, FINRA TRACE, or fund fact sheet)
2. Look up the issuer's Debt/EBITDA ratio (10-K filing, earnings release)
3. Check interest coverage (EBITDA/Interest expense)
4. Compare to the thresholds above

Interpretation:

• Leverage below 3x with coverage above 5x: Solid investment grade characteristics
• Leverage 4-5x with coverage 3-4x: Borderline—verify qualitative factors
• Leverage above 5x or coverage below 2.5x: High yield territory regardless of stated rating

Action: If you find an issuer rated BBB but showing B-like leverage metrics, that's a fallen angel candidate. Consider whether you want that exposure—or whether the rating is about to catch up with reality.

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References

1. Moody's Investors Service. (2021, updated 2024). "Corporates Rating Methodology." Moody's Ratings.
2. S&P Global Ratings. (2025). "2024 Annual Global Corporate Default and Rating Transition Study."
3. RapidRatings. (2024). "2024 Annual Default Review."
4. Livingston, M., & Zhou, L. (2010). "Split Bond Ratings and Rating Migration." Journal of Banking & Finance.
5. Financial Crisis Inquiry Commission. (2011). "The Financial Crisis Inquiry Report."
6. U.S. Securities and Exchange Commission. (2008-2022). Various enforcement actions and rule releases on NRSROs.