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Foreign. Hi, I'm Andy Tempte and welcome to Money Lessons. Join me every Saturday morning for bite sized lessons that are designed to improve financial literacy around the world. Today is February 7, 2026. Last week we explored why some bonds pay more than others, discovering how credit spreads measure the extra yield investors demand for taking on risk. Beyond risk free treasury bills and bonds that we've previously talked about, we introduced the distinction between investment grade and high yield bonds and learned that basis points are the language bond professionals use to discuss interest rate changes. But here's the question we left unanswered. How do investors actually know which bonds are risky and which are relatively safe? The answer lies in credit ratings, which are letter grades assigned to bonds that summarize months of detailed financial analysis into a simple, comparable measure. Today we're exploring how credit ratings work and why they've become essential infrastructure for modern bond markets. Now picture yourself as an investor in 1905. Railroads dominate the American finance scene, and dozens of companies have issued hundreds of different bonds. Each railroad has complex capital structures with senior bonds, junior bonds, and various mortgage arrangements. How do you evaluate which ones are safe and which might end up in default? You could hire analysts to study financial statements, interview management and assess industry conditions. But this requires expertise, time and resources most in investors lack. John Moody saw this problem and created a solution that would transform bond markets forever. Back in our December 27 episode on corporate bonds, we briefly introduced John Moody and his revolutionary contribution to bond markets. Today we're going to go just a little bit deeper. So in April 1909, Moody published Moody's analyses of railroad investments. Moody had built his reputation at one of the era's prominent investment banks before the panic of 1907 forced him to sell his earlier publishing business. His new publication did something that no investor guide had done before. It applied a consistent letter grade rating System to nearly 1300 railroad bonds. Moody borrowed the letter grade concept from Mercantile credit reporting firms, but he was the first to apply this approach systematically to bonds. The genius was in the simplicity. Instead of wading through pages of financial data, an investor could glance at a rating and immediately understand a bond's relative quality. A bond rated AAA was among the safest available. A bond rated Single B carried significantly more risk. The letter grades created a common language for discussing credit quality. Research shows that Moody's ratings had immediate market impact. Bonds receiving worse than expected ratings saw their yields rise, meaning their prices fell as investors demanded more compensation for this newly clarified risk. Moody's success attracted competition, as you might imagine Poor's Publishing Company began selling bond ratings in 1916, Standard Statistics Company followed in 1922 and Fitch Publishing Company entered in 1924. As we've discussed previously, Poor's and Standard Statistics later merged to form Standard and Poor's, creating the rating agency landscape that persists today. These three firms, Moody's, Standard and Poor's and Fitch are known as the Big Three, and they control approximately 95% of the global ratings business. Now, annoyingly, each agency uses a slightly different notation, but the scales are designed to be comparable. For the rest of this episode, I'm just going to use the S and P rating system so that I don't confuse the crap out of you. The highest ratings, which are AAA, ByStandard and Poor's, indicate the lowest expectation of default. These bonds come issuers with exceptionally strong capacity to meet their financial commitments. As of 2025, only two American companies, Microsoft and Johnson and Johnson, maintain AAA ratings from Standard and Poor's. Interestingly, Apple holds Moody's top AAA rating but is rated only AA by S and P, illustrating how agencies can reach slightly different conclusions. Moving down the scale, AA ratings indicate very low default risk, while single A ratings suggest low risk that may be somewhat more vulnerable to adverse conditions. BBB ratings, which are the lowest investment grade tier, indicate adequate capacity to meet obligations, although adverse conditions could impair this capac. Below BBB minus we enter high yield territory. BB ratings indicate elevated risk. Single B ratings suggest significant vulnerability. Triple C and below indicate substantial credit risk where default is a real possibility. And well, if you got a D on the exam, you're already in default. So what drives a credit rating? Rating agencies evaluate both quantitative and qualitative factors when assigning ratings. The quantitative factors provide the mathematical foundation. Agencies examine debt levels relative to equity and earnings. They calculate interest coverage ratios or how many times over can the company's earnings cover its interest payments. They analyze cash flow patterns, looking for stable, predictable cash generation that can reliably service debt. We'll explore these financial ratios in detail in future episodes. Now the qualitative factors require judgment. As you might imagine, analysts assess management quality, competitive position, regulatory environment, economic conditions, and the company's track record of meeting obligations. The rating reflects the agency's forward looking opinion about the issuer's ability and willingness to make payments on time. Now, ratings are not static. They change as issuers circumstances evolve. Upgrades typically cause bond prices to rise as investors accept lower yields. Downgrades cause prices to fall as investors demand higher compensation. These price movements can be substantial, especially when ratings cross the critical investment grade threshold. Now agencies also assign outlooks which are positive, negative, stable or developing. So they issue the rating and then also the outlook, indicating the likely direction of future rating changes. Now historical default rates demonstrate why ratings matter. AAA rated bonds have shown a cumulative default rate of just 0.52% over 10 year investment periods. Triple B rated bonds, the lowest investment grade, showed approximately 1.6% cumulative defaults over a five year holding period. The jump into high yield territory is dramatic. B rated bonds have historically shown default rates approaching 24% over 10 year holding periods. For the lowest rated triple C bonds, default rates can approach 50% over extended periods of time. These statistics validate what the rating system promises. Higher ratings genuinely correspond to lower default risk. Now credit ratings have become essential infrastructure for bond markets, but they're not perfect Next week we'll explore what happens when ratings fall. Examining Historical Examinating what the heck is that? Examining historical episodes from Penn Central to enron to the 2008 financial crisis that revealed the limitations and conflic Netflix embedded in the rating system. We'll do a lot of examinating then. Until next week, I wish you grace, dignity and compassion. My name is Andy Tempte. This is Money Lessons. You can find the show on all the major streaming services as well as out on YouTube. Please like subscribe, rate and most importantly, share this public good with your friends, your family, your colleagues, and maybe a neighbor. The show was produced by Nick Tempte and we'll see you next time on Money Lessons.