Bond Credit Ratings: Investment Grade versus Junk
Credit ratings from agencies such as Moody’s, Standard & Poor’s, and Fitch grade a bond’s default risk on a scale running from the top AAA down to D (in default). The key dividing line splits investment grade from high-yield, or junk, bonds at BBB- (S&P and Fitch) and Baa3 (Moody’s). Lower ratings generally carry a larger default risk premium, though the market spread is a price that also reflects liquidity, risk appetite, and taxes, so rating and spread are correlated rather than identical.
Why it matters
A rating is a shorthand verdict on how likely the borrower is to miss a payment, so it sits right on top of the risk-structure idea that riskier bonds must pay more. When a bond is downgraded across the investment-grade line, many institutions are forced to sell it, so its price falls and its yield jumps.
Worked examples
A bond rated BBB- is downgraded to BB+. What has changed about how the market and many investors treat it?
It has crossed from investment grade into high-yield, or junk, territory. Its assessed default risk is now higher, so its default risk premium and yield rise, and funds restricted to investment-grade holdings may be forced to sell it, pushing the price down further.
Common mistakes
- ✗A high rating guarantees the bond will not default. Ratings are an opinion on relative default risk, not a guarantee, and even highly rated issuers can be downgraded or default.
- ✗Junk bonds are worthless or fraudulent. High-yield bonds simply carry more default risk, so they pay a larger risk premium to compensate investors.
- ✗The investment-grade line is just a label. It is a hard threshold for many institutions, so crossing it can force selling and move the price sharply.
Revision bullets
- •Ratings grade default risk from AAA down to D
- •Investment grade vs junk splits at BBB-/Baa3
- •Lower ratings map to a larger default risk premium
Quick check
The dividing line between investment-grade and high-yield (junk) bonds sits at
Connected topics
Sources
- Mishkin (2018), Ch. 6Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.Bond ratings within the risk structure of interest rates and the investment-grade versus junk distinction.