How the Moody’s Rating Scale Works

Moody’s rating scale could help investors evaluate the creditworthiness of corporations, governments and financial institutions when researching investment strategies. Developed by Moody’s Investors Service, this scale aims to determine the likelihood that an entity will have to meet its financial obligations, guiding investors in making decisions about their portfolios. It provides a standardized method to assess credit risk and offers insights into the safety of investments based on the issuer’s financial health.

If you’re building a portfolio, a financial advisor can work with you to identify investment opportunities and determine the level of risk.

What Is Moody’s and What Does It Rate?

Founded in 1909 by John Moody, the company began by providing financial analysis on railroad bonds and quickly gained a reputation for its thorough and reliable assessments. Today, Moody’s has grown into one of the leading authorities in creditworthiness for investors, governments and businesses. The service rates a wide range of financial products, including corporate bonds, government securities, municipal bonds and structured finance products.

Moody’s ranks entities and securities based on their likelihood of default. This information can help investors build out their risk profiles. The ratings provided by Moody’s also influence borrowing costs for entities, as higher ratings typically result in lower interest rates.

The company’s ratings help maintain transparency and stability in the global financial system by providing an independent assessment of credit risk. Moody’s long history and broad influence have made it a cornerstone in the economic and financial industries, trusted by top financial advisors worldwide.

What Is the Moody’s Ratings Scale?

Moody’s rating scales are broken down into two primary categories: investment grade and speculative grade.

Investment grade ratings range from Aaa, the highest possible rating, to Baa3. These ratings suggest that the rated entity or security has a relatively low default risk and is generally seen as stable. Aaa-rated entities are considered to have the strongest ability to meet their financial obligations, while Baa3 represents the lowest rung of the investment-grade ladder.

Below Baa3 ratings enter the speculative grade, or “junk” grade, which indicates higher risk. These ratings range from Ba1 to C, with C suggesting that the entity is in default or near default with little prospect of recovery. The speculative ratings mean that the entities are more vulnerable to adverse economic conditions, making them riskier investments.

Each rating is supplemented with a modifier of 1, 2, or 3 to provide further granularity. For example, a Baa1 rating is higher than Baa2 but lower than A3. This system helps investors differentiate between varying levels of risk within the same rating category.

Moody’s vs. S&P vs. Fitch

Moody’s, S&P, and Fitch are the three leading credit rating agencies globally, each offering a distinct but broadly similar rating system to assess creditworthiness. While all three agencies provide ratings that range from high-quality to speculative and default categories, their scales and ratings differ slightly.

Moody’s ratings use a combination of letters and numbers, such as Aaa, Aa, and A, with numerical modifiers (1, 2, 3) to indicate relative standing within each category. S&P and Fitch, on the other hand, use a simpler letter-based scale like AAA, AA, and A, with modifiers like pluses (+) and minuses (-) to provide additional granularity.

The top ratings for all three agencies—Aaa for Moody’s and AAA for S&P and Fitch—indicate the highest credit quality with minimal risk. However, while Moody’s C rating indicates default or near default, S&P and Fitch differentiates both further with a D rating, which explicitly indicates default. Fitch also has an RD rating to signify an entity that has defaulted on payments but hasn’t entered into bankruptcy or liquidation.

Despite these differences, the three agencies’ ratings are widely recognized and trusted by investors, providing important insights into the risk level of various types of investments and entities. The choice between them often depends on regional preferences or the specific type of analysis an investor requires.

Bottom Line

Moody’s rating scale evaluates the creditworthiness of entities like corporations and governments, helping investors assess credit risk. While the ratings offer useful information, they do not determine investment strategy on their own. Investors can consult a financial advisor to understand how these ratings impact their long-term financial goals.

Tips for Investing

• A financial advisor can help you analyze and manage investments for your portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

• If you want to know how much an investment could grow over time, SmartAsset’s free investment calculator could help you get an estimate.

Photo credit: ©iStock/william87, ©iStock/LumiNola, ©iStock/nd3000

The post How the Moody’s Rating Scale Works appeared first on SmartReads by SmartAsset.