CFA Level I Exam · Credit Risk

Credit Ratings and Their Limitations for CFA Level I

Updated 7 October 2026 · Fact-checked

A credit rating is an agency's opinion of a borrower's or a bond's creditworthiness. Investment grade means BBB-/Baa3 or higher; high yield is below that. Issuer ratings cover the borrower, issue ratings cover a specific bond, and notching moves the issue rating up or down for seniority and security. Ratings lag and can be wrong.

Understand Credit Ratings and Their Limitations

A credit rating is an independent opinion on how likely a borrower is to repay, and sometimes on how much you lose if it does not. Agencies such as S&P Global Ratings, Moody's and Fitch publish ratings. Investors use them as a quick screen and as a common language for credit risk.

Ratings split into two broad groups. Investment grade runs from the top rating down to BBB- (S&P and Fitch) or Baa3 (Moody's). High yield, also called speculative grade or junk, is BB+/Ba1 and below. The line matters in practice: many mandates, regulations and index rules only allow investment grade holdings. Bonds in the high yield group pay higher yields because default risk is higher.

An issuer rating (corporate family rating) measures the borrower's overall ability to meet its senior unsecured obligations. An issue rating applies to one specific bond or loan. It can differ from the issuer rating because of seniority, collateral and structure. Notching is the adjustment of the issue rating up or down from the issuer rating. A subordinated bond is usually notched down, because in default it is paid after senior creditors and recovers less. A senior secured bond may be notched up, or kept level, because collateral supports recovery. Agencies may also notch unsecured debt down further when a firm has a lot of secured debt, since that pushes unsecured creditors further back in the queue. Structural subordination is a separate idea: it arises when debt sits at operating subsidiaries, so creditors of the holding company rank behind the subsidiary's creditors.

Ratings have limits. They are lagging: agencies avoid reversing ratings too quickly, so market spreads often move before a rating does. Ratings are not precise: two bonds with the same rating can have different default risk and spreads. Credit migration risk (downgrade risk) is the risk that the rating falls, which widens the spread and cuts the bond's price even without default. There is also event risk, such as a leveraged buyout, which can cause a sudden multi-notch downgrade. Other limits include the issuer-pays model, which creates a conflict of interest, and the fact that complex structured products have been rated too generously in the past. Ratings also cover credit risk only, not interest rate or liquidity risk.

So use ratings as one input. Combine them with your own analysis, such as the four Cs, and with market-implied information such as credit spreads.

Key formulas to remember

Investment grade boundary: Investment grade: BBB- or higher (S&P, Fitch); Baa3 or higher (Moody's). High yield: BB+ / Ba1 or lower; A split rating (for example BBB- from one agency and BB+ from another) is a common trap; check each agency's scale.
Notching rule of thumb: Issue rating = issuer rating ± notches for seniority and security; Subordinated or unsecured-behind-secured: notch down. Strong collateral or senior ranking: level or up. Exact notches vary by agency.
Expected loss: Expected loss = Probability of default × Loss severity; Loss severity = 1 − recovery rate. Issuer ratings mostly reflect default probability; issue ratings also reflect recovery.
Approximate price effect of a spread change: %ΔPrice ≈ −Modified duration × ΔSpread; Use for downgrade (migration) risk when the yield change comes from a wider spread. Ignores convexity.

How to solve Credit Ratings and Their Limitations questions

Use this method for any question on ratings, notching or their limits.

1Identify what is being rated: the issuer or a specific issue.
2Locate the rating on the scale and decide whether it is investment grade (BBB-/Baa3 or above) or high yield.
3Check seniority and security of the bond in the question. Subordinated means notch down; senior secured means level or up.
4Ask whether the question is about default probability, loss severity, or both. Issuer ratings lean to default probability; issue ratings add recovery.
5If the question involves a downgrade, think credit migration risk: spread widens, price falls, and use duration × spread change for size.
6For limitations questions, match the statement to a known weakness: lag, imprecision, conflict of interest, event risk, structured product errors.
7Eliminate any option that overstates what a rating can do (for example, guaranteeing no default).

Quickest way: Three-check shortcut

When to use it: Use under time pressure on conceptual questions with three options.

Check the boundary: is it BBB-/Baa3 or higher? If yes, investment grade.
Check ranking: lower ranking means lower rating than the issuer rating; higher ranking or collateral means equal or higher.
Check the limit: if an option says ratings are timely, precise or guarantees, drop it. Ratings lag and are opinions.

Common mistakes in Credit Ratings and Their Limitations

Treating BB+ or Ba1 as investment grade.
Students remember 'B' letters as one group and forget where the cut-off falls.
Fix: Memorise that the lowest investment grade rating is BBB- (Baa3). Anything one step lower is high yield.
Assuming the issue rating always equals the issuer rating.
Both are about the same company, so they seem identical.
Fix: Remember notching: seniority and collateral change recovery, so a subordinated bond is usually rated below the issuer rating.
Notching a subordinated bond up instead of down.
Confusing 'subordinated' with 'senior'.
Fix: Subordinated means paid later and recovers less, so it is rated lower. Ask 'who is paid first?'
Believing ratings change as soon as credit quality changes.
Students assume agencies react as fast as markets.
Fix: Ratings lag. Agencies aim for stable ratings through the cycle, so spreads often move first.
Confusing credit migration risk with default risk.
Both involve credit deterioration.
Fix: Default risk is non-payment. Migration risk is a downgrade that widens the spread and cuts the price while the issuer still pays.
Thinking a rating covers all risks of a bond.
A high rating feels like a safe label.
Fix: A rating addresses credit risk only. Interest rate risk, liquidity risk and others remain.

Worked examples

Example 1

A company has an issuer rating of BBB (S&P scale). It has senior secured bonds and subordinated bonds outstanding. Which statement is most consistent with notching? A) The subordinated bonds are likely rated below BBB and may be high yield. B) The subordinated bonds are likely rated above BBB because they pay a higher coupon. C) Both bonds must be rated exactly BBB.

Show the solution

Identify the issuer rating: BBB, which is investment grade and one notch above the lowest investment grade rating, BBB-.
Subordinated bonds rank behind senior creditors, so recovery is lower.
Lower recovery means the issue rating is notched down from BBB. The number of notches varies by agency and by how much senior debt ranks ahead of the subordinated bonds. A one-notch cut gives BBB-, which is still investment grade. A two-notch cut gives BB+, which is high yield. So the subordinated bonds are rated below BBB and may fall into high yield.
The senior secured bonds are rated level with BBB or notched up, because collateral supports recovery.
Option B is wrong: a higher coupon compensates for risk; it does not raise the rating.
Option C is wrong: ratings need not equal the issuer rating after notching.

Answer: A

Example 2

A bond with a modified duration of 6.0 is downgraded, and its credit spread widens by 50 bps, with no change in benchmark yields. Estimate the price change using duration only (ignore convexity). A) −3.0% B) −0.3% C) +3.0%

Show the solution

Convert the spread change: 50 bps = 0.50% = 0.0050.
Apply %ΔPrice ≈ −Modified duration × ΔSpread. This duration-only estimate ignores convexity, so it is an approximation.
−6.0 × 0.0050 = −0.030.
This is −3.0%. A widening spread lowers the price, so C (positive) is wrong.
B results from misplacing the decimal.

Answer: A (approximately −3.0%)

Exam tips

Know the investment grade cut-off on both the S&P/Fitch and Moody's scales; questions often test the boundary.
When you see 'subordinated', 'unsecured' or 'secured', think notching straight away.
Limitation questions usually have one option claiming ratings are timely or exact; reject it.
For migration risk, a downgrade means wider spread and lower price; use duration × spread change for size.
With no penalty for wrong answers, always answer. Eliminating one clearly wrong option leaves a 50% chance between the remaining two.

Practice questions from Credit Risk

Credit Ratings and Their Limitations in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Credit Ratings and Their Limitations: frequently asked questions

What is the difference between investment grade and high yield?

Investment grade bonds are rated BBB-/Baa3 or higher; high yield bonds are rated BB+/Ba1 or lower. High yield bonds carry greater default risk and so offer higher yields. Many investors can hold only investment grade bonds.

What is notching in credit ratings?

Notching is raising or lowering a specific bond's rating relative to the issuer rating. It reflects seniority and collateral, which affect recovery if the issuer defaults. Subordinated debt is usually notched down.

What is the difference between an issuer rating and an issue rating?

An issuer rating assesses the borrower's overall creditworthiness. An issue rating applies to one specific debt instrument and takes account of its ranking and security. The two can differ.

What are the main limitations of credit ratings?

Ratings lag market information, are not precise measures of default risk, can suffer from conflicts of interest under an issuer-pays model, and may miss sudden event risk. They also cover only credit risk. Use them alongside your own analysis and credit spreads.

What is credit migration risk?

It is the risk that an issuer's rating is lowered, causing the spread to widen and the bond's price to fall. It can hurt returns even if the issuer never defaults.