A Hurdle of Practical Importance

The clear divide between investment-grade and speculative-grade debt markets dates back decades.

A number of central banks make their bond purchase programs dependent on minimum credit ratings. These are often operationalized by specifying rating symbols, such as the rating symbols Baa3 or BBB-. When a rating agency tries to win paid orders from issuers by giving benevolent ratings above this threshold, it is damaging the system on a very fundamental level. The rating agency Moody’s Investors Service has now presented an in-depth analysis with which it shows – inter alia – why it takes this threshold so seriously.

“Between the 1930s and the late 1970s,” tells Moody’s, “investment-grade companies issued almost all public bonds in the US, and the speculative-grade (or high-yield) bond market consisted solely of companies that had been downgraded out of investment grade (i.e., fallen angels).”

According to Moody’s, it was not until the early 1980s in the US, and later outside of the US, that a robust speculative-grade public bond market emerged and grew rapidly, fueled mainly by private equity-sponsored leveraged buyouts. Since the 1980s, the high-yield market has continued to expand as its own asset class with distinct investor groups. As a result, a clear divide has been maintained between the investment-grade and speculative-grade debt markets.

The classification is still at least as important today as it was in the past. Increases in credit spreads and losses at the investment-grade/speculative-grade divide are relatively large. One factor underlying the importance of this divide is the relatively large percentage changes in corporate credit spreads and losses when moving from investment grade to speculative grade, and vice versa.

“The percentage increase in spreads moving from Baa3 to Ba1 is materially larger than at almost all other points on the rating scale,” says Moody’s, “both in the first half of 2021 and over a longer period from 1991 through 2020.” Another finding in Moody’s report: “The investment-grade and speculative-grade divide delineates a difference in historical credit losses between Baa3- and Ba1- rated nonfinancial companies that is larger than at most other points on the rating scale.”

According to the data published by Moody’s, these relatively large differences across the Baa3/Ba1 divide are long-standing. “Regulations and portfolio governance rules that hinge on the distinction between investment-grade and speculative-grade ratings have led to these differences and have driven differences in financial policies and liability structures.”

See Moody’s Investors Service, Sector In-Depth: Corporates – Global, A closer look at the investment-grade / speculative-grade divide.