What does a credit rating actually tell me?Some background helps

One opinion about one question: will this borrower pay on time? Not whether the price is fair, and not how much you get back if they don't.

A rating is an opinion from an agency about how likely a borrower is to pay what it owes, on time. Three firms produce most of them: S&P, Moody's and Fitch. The letters run from AAA at the top down through BBB, then below that into what the market calls high yield, and finally to D for a borrower that has already defaulted.

Where is the line that matters?

Between BBB− and BB+. Above it is investment grade; below it is not. Nothing about the borrower changes much across that line, but a great deal about who is allowed to own the bond does. Many pension funds and insurers are restricted to investment grade, and many index funds track investment-grade indices.

So a downgrade across that line forces selling by people who have no view at all, which moves the price more than the change in credit quality justifies. Bonds that make the trip have a name — fallen angels — and the effect is one of the more reliable patterns in credit markets.

What does the rating deliberately not tell me?

Three things, and all three get assumed anyway.

It is not a view on price. A rating says how likely default is. It says nothing about whether the yield on offer pays you enough for that. A BB bond at 9% may be excellent value and a BB bond at 5% may be terrible; the rating is identical.

It is not about how much you lose. Ratings from the main agencies address probability of default, not what you recover afterwards. A senior secured loan and an unsecured bond from the same company default together, and recover very differently.

It is not about the price falling. A bond can lose a third of its value on a downgrade that never becomes a default. Rating risk and market risk are separate things.

Who pays for the rating?

The borrower does, in the main model. The company that wants to sell bonds pays the agency to rate them. Everyone can see the conflict, and the agencies manage it with committees, published methodologies and separation of staff.

It mostly works for ordinary corporate and government debt, where the agency's reputation is worth more than any single fee. It worked far less well for structured products in the run-up to 2008, where issuers could shop between agencies for the rating they needed and the volume of business was enormous. The subprime story is largely a story about that.

Was a AAA on a mortgage bond the same as a AAA on a government?

No, and this is the most useful thing on this page. The letters were the same. What sat behind them was not.

A government's rating rests on its economy and its willingness to pay. A structured product's AAA rested on a model of how likely it was that many mortgages would go bad at once. The rating was only ever as good as that assumption, and the assumption was that house prices do not fall everywhere at the same time. When they did, tranches went from AAA to defaulted in months — a move that has essentially never happened to a rated government.

Same letters, entirely different fragility. Securitisation is where that machinery is explained.

How should I actually use one?

• As a starting sort, not a conclusion. It tells you which pile a bond is in.
• Look at the outlook and any watch status — that is the agency telling you which way it is leaning.
• Compare the yield to other bonds with the same rating. A bond paying much more than its peers is the market disagreeing with the agency, and the market is often earlier.
• Ask what the rating is rating: a company, or a model.

The credit rating playbook goes through a real rating report line by line.