How credit ratings work
A rating is an opinion with a conflict of interest attached, not a measurement.
Read a rating for what it is worth, which is something, but less than it looks.
How credit ratings work works, in one picture
The same argument as the text, as a chain. Each step is what makes the next one possible.
The fee you never see
You buy at the ask and sell at the bid, so you are down the spread the instant you trade. In an illiquid stock it dwarfs any commission you thought you were avoiding.
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The scale runs from AAA to default
Anything below BBB minus is 'high yield', which is the polite phrase, or 'junk', which is the honest one. Lower rating means the borrower must pay more, because you are being compensated for a real probability of not being repaid.
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The issuer pays for the rating
The company being rated hires and pays the agency rating it. This is as obviously problematic as it sounds, and it is the model the entire industry runs on.
In 2008, mortgage securities that were rated AAA turned out to be worthless. The ratings were not merely wrong, they were the reason institutions were permitted to buy them.
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Downgrades are forced selling events
Many funds are contractually barred from holding sub-investment-grade debt. When a bond is downgraded across that line, they must sell, regardless of price or view. That is a mechanical wave of selling caused by an opinion.
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Use the spread instead
The gap between junk yields and government yields is a live, money-backed measure of how much risk the market perceives, updated by the second. It is a better fear gauge than any letter grade.
You treat a rating as one input, and the credit spread as the honest one.
Read next
A rating is an opinion with a conflict of interest attached, not a measurement.
Price to book and return on equity read together, which is the only way a bank makes sense.