Skip to content

FRM Exam Part II · Credit Scoring and Rating

Credit Rating Agency Methodologies for FRM Part II

Updated 11 October 2026 · Fact-checked

Rating agencies such as S&P, Moody's and Fitch assess a borrower's ability and willingness to repay. They combine business and financial risk analysis, committee review and surveillance to assign an issuer rating, then notch issue ratings up or down for seniority, security and expected recovery. Ratings are ordinal opinions on a letter scale, not exact default probabilities.

Understand Credit Rating Agency Methodologies

A credit rating is an agency's opinion on the relative creditworthiness of a borrower or a debt instrument. It ranks credit risk. It does not give an exact probability of default. Investors, banks and regulators use ratings as a shared language for credit quality.

There are two kinds of rating. An issuer rating (also called a counterparty or corporate family rating) measures the borrower's overall capacity to meet its financial obligations. An issue rating applies to one specific debt instrument. It starts from the issuer rating and is adjusted for the features of that instrument: seniority, security or collateral, guarantees, and expected recovery if default happens. A senior secured bond can be rated above the issuer rating. A subordinated bond is usually rated below it. This adjustment is called notching.

Agencies analyse two broad areas. Business risk covers industry strength, competitive position, scale, diversification and management quality. Financial risk covers leverage, cash flow coverage, profitability, liquidity and financial policy. For corporates, typical ratios are debt to EBITDA, funds from operations to debt and interest coverage. Agencies also review governance, country and sovereign risk, and the legal framework. A corporate is usually rated no higher than its sovereign, though exceptions exist.

A rating is decided by a rating committee, not one analyst. The analyst proposes a rating, the committee votes, and the issuer can appeal with new information. After that the agency runs surveillance. It publishes outlooks (positive, stable, negative) and places names on watch when a change is likely soon. Most agencies aim for ratings that are stable through the cycle, so they look through short-term swings and move slowly. This is called through-the-cycle rating. It contrasts with point-in-time approaches, which react quickly to current conditions.

The scales are similar. S&P and Fitch use AAA, AA, A, BBB, BB, B, CCC, CC, C and D, with + and - modifiers. Moody's uses Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C, with numerical modifiers 1, 2 and 3. The cut-off is investment grade (BBB- or higher at S&P and Fitch, Baa3 or higher at Moody's) versus speculative grade (below that, also called high yield).

Key formulas to remember

Investment-grade boundary
S&P / Fitch: BBB- and above. Moody's: Baa3 and above.
Anything below is speculative grade (high yield). Bonds are one notch from the boundary at BB+ / Ba1.
Scale mapping (full letter grades)
S&P/Fitch: AAA, AA, A, BBB, BB, B, CCC, CC, C, D. Moody's: Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C.
Moody's uses 1, 2, 3 modifiers (Aa1 = AA+, Aa3 = AA-). S&P and Fitch use + and -.
Issue rating via notching
Issue rating = Issuer rating ± notches for seniority, security, guarantees and expected recovery
Senior secured is notched up or equal. Subordinated is notched down. Number of notches differs by agency and by issuer grade.
Rating philosophy
Through-the-cycle = stable, looks through the cycle. Point-in-time = responsive to current conditions.
Agency ratings are mainly through-the-cycle. This makes transitions slow and causes cliff effects.
Rating meaning
Rating = ordinal ranking of credit risk, not a fixed PD
Default rates rise as ratings fall, but the PD for a grade changes with the cycle.

How to solve Credit Rating Agency Methodologies questions

Use this sequence for any question on how agencies rate issuers and issues.

  1. 1Decide what is being rated: the issuer (overall borrower) or a specific instrument (issue).
  2. 2If it is an issue, start from the issuer rating, then check seniority, security, guarantees and recovery to decide the notching direction.
  3. 3Check which drivers the question points to: business risk, financial risk, governance, or sovereign and country limits.
  4. 4Identify the rating philosophy: through-the-cycle (agencies) or point-in-time (many internal models).
  5. 5Convert between scales carefully. Match S&P/Fitch letters to Moody's, including modifiers.
  6. 6Test against the investment-grade line (BBB- / Baa3) if the question mentions regulation, funds or eligibility.
  7. 7Choose the option that treats the rating as an ordinal opinion, not a precise PD, unless the question gives default data.

Quickest way: Three-check shortcut

When to use it: Use for scale conversion and issuer-versus-issue questions with limited time.

  1. Map the scale: Baa = BBB, Ba = BB, Caa = CCC. Moody's 1/2/3 = S&P +/flat/-.
  2. Mark the investment-grade line: BBB- or Baa3.
  3. For issue ratings ask: is this claim senior and secured (up), or subordinated (down)?

Common mistakes in Credit Rating Agency Methodologies

  • Treating issuer and issue ratings as the same thing

    Both appear as a single letter grade on the same company.

    Fix: Remember the issue rating adjusts the issuer rating for the instrument's seniority, security and recovery.

  • Mapping Moody's Baa3 to S&P BBB+

    Students match the number 3 with a plus sign.

    Fix: Moody's 1 = high end (+), 2 = middle, 3 = low end (-). Baa3 = BBB-.

  • Saying a rating equals an exact default probability

    Default tables link grades to average default rates.

    Fix: A rating is an ordinal opinion. Historical average default rates differ by grade and move with the cycle.

  • Calling agency ratings point-in-time

    Ratings are updated often, so they seem responsive.

    Fix: Agencies target through-the-cycle stability and avoid reacting to temporary changes.

  • Ignoring sovereign and country ceilings

    Focus stays on company ratios.

    Fix: Check whether country risk, transfer risk or sovereign rating limits the corporate rating.

  • Thinking only financial ratios drive ratings

    Ratios are easy to compute.

    Fix: Add business risk, management, governance and financial policy. Agencies use both quantitative and qualitative inputs.

Worked examples

Example 1

A company has an issuer rating of BBB (S&P). It has issued senior secured bonds and subordinated bonds. Which statement is most consistent with agency practice?

Show the solution
  1. Identify the issuer rating: BBB.
  2. Issue ratings start from the issuer rating and are notched for seniority, security and expected recovery.
  3. The senior secured bond has better recovery prospects, so its rating is equal to or above BBB.
  4. The subordinated bond has weaker recovery prospects, so its rating is typically below BBB, for example BBB- or BB+.
  5. Note that BBB- is still investment grade, while BB+ is speculative grade.

Answer: The senior secured bond is rated at or above BBB and the subordinated bond is rated below BBB. The exact notches depend on the agency and the recovery assessment.

Example 2

A fund may hold only investment-grade debt. Which one of these bonds does the mandate allow: S&P BB+, Moody's Ba1, Fitch BBB-, or Moody's B2?

Show the solution
  1. Investment grade means BBB- or above at S&P and Fitch, and Baa3 or above at Moody's.
  2. S&P BB+ is one notch below BBB-, so it is speculative grade.
  3. Moody's Ba1 is one notch below Baa3, so it is speculative grade.
  4. Fitch BBB- is exactly on the boundary, so it is investment grade.
  5. Moody's B2 is deep in speculative grade.

Answer: Only the Fitch BBB- bond is permitted.

Exam tips

  • Practise converting between S&P, Fitch and Moody's including the modifiers. Questions often hide the answer in the boundary notch.
  • When a question asks why a bond is rated differently from its issuer, think seniority, security, guarantees and recovery first.
  • Watch for words like 'through-the-cycle', 'stable' and 'outlook'. They point to agency philosophy, not market-implied measures.
  • Eliminate options that say a rating is a precise PD or a guarantee of performance.

Practice questions from Credit Scoring and Rating

Credit Rating Agency Methodologies in other exams

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

Credit Rating Agency Methodologies: frequently asked questions

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

An issuer rating shows the borrower's overall ability to meet its obligations. An issue rating applies to one instrument and adjusts the issuer view for seniority, security, guarantees and expected recovery.

How do S&P, Moody's and Fitch scales compare?

S&P and Fitch use AAA to D with + and - modifiers. Moody's uses Aaa to C with 1, 2 and 3. Investment grade ends at BBB- for S&P and Fitch and at Baa3 for Moody's.

How do rating agencies assign credit ratings?

An analyst reviews business and financial risk, governance and country factors, then proposes a rating. A committee votes on it and the issuer is informed. The agency then monitors the rating and may change the outlook or the grade.

Are agency ratings through-the-cycle or point-in-time?

They are mainly through-the-cycle. Agencies try to avoid frequent changes from temporary conditions, so ratings are more stable but can lag the market.