Why the Investment-Grade Credit Rating Boundary Exists
Summary
The document considers why Moody’s Baa3 and S&P’s BBB− mark the lower edge of investment grade, and whether default risk changes sharply at that point. One reply directs readers to published default and rating-transition tables as evidence to examine. Another argues that adjacent rating categories have broadly comparable credit risk and that the boundary became important through regulatory rules that made ratings consequential for institutional investors.
A further reply cites a European regulatory mapping that reportedly shows a jump in a default-rate measure across the boundary. These responses offer competing explanations: the threshold may function as a regulatory dividing line even if risk changes gradually, while some tabulations may show a marked increase nearby. The document does not present the cited tables or clarify their horizons, populations, or methodologies, so it cannot establish a universal discontinuity in default risk or settle how much of the boundary is conventional.
Key ideas
- Published default and rating-transition studies can be used to compare risk across rating categories.
- One response argues that adjacent ratings have comparable credit risk and that regulation gave the boundary practical force.
- Another response cites a regulatory default-rate mapping as evidence of a substantial increase near the threshold.
- The discussion does not provide enough methodological detail to establish a universal jump in risk.
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Full text
# Why investment grade floor is set at Baa3/BBB-? # Why investment grade floor is set at Baa3/BBB-? I have studied methodologies for Moody's and S&P ratings but haven't seen any instance where the respective agencies have mentioned the reason choosing Baa3/BBB- as the dividing line between investment grade and junk issues. Is there any research which shows that default risk shoots up at a significantly faster rate when the issuer is rated 1-notch lower than Baa3/BBB- barrier or are these rating floors (for IG grade) arbitrary? Any help would be deeply appreciated. ## Answer by AlRacoon (score 3, accepted) https://quant.stackexchange.com/a/71062 Cumulative default and transition rates for s&p credit ratings can be found here: https://www.spglobal.com/ratings/en/research/articles/210407-default-transition-and-recovery-2020-annual-global-corporate-default-and-rating-transition-study-11900573 Chart 4 and Table 3 are very useful for answering your question. ## Answer by Dimitri Vulis (score 6) https://quant.stackexchange.com/a/71064 The differences in credit risk between Moody's Baa2 versus Baa3 versus Ba1 versus Ba2 are all comparable. People would pay much less attention to agency ratings had the regulators not forced them to. In 1936, the OCC prohibited the N.A. banks to own "speculative investment securities," as determined by "recognized rating manuals" (Banking Act of 1935, Section II). In 1975 the SEC rebranded credit rating agencies to "NRSROs", creating a cartel. In 1989, this rule was extended to more institutions (not just national banks), who suddenly were mandated to sell a lot of HY bonds at fire sale prices. Their portfolio managers did not think Ba was too risky before government burecaucrats told them so - did not in fact care about agency ratings much. Goverment bureaucrats just needed some arbitrary boundary between IG and HY, so they decided to draw the line here. I'll try to illustrate this concept with Google Streets: https://www.google.com/maps/@40.7822931,-73.7161662,3a,75y,113.75h,94.82t/data=!3m6!1e1!3m4!1sVxOjS9g44SugJ7YKm6IhTQ!2e0!7i16384!8i8192 This is Northern Boulevard (aka Route NY-25A). The structures on the left and on the right are in Queens Country - New York City. The structure is the middle is Nassau County - the hamlet of Manhasset. There is no logical reason why the county line should be here, but this how it got drawn back when this was all farmland. ## Answer by Deno (score 4) https://quant.stackexchange.com/a/71061 Yeah, default rate jumps considerably. For example in following, mid value of default rate jumps from 1% to 7.5 % : "COMMISSION IMPLEMENTING REGULATION (EU) 2016/1799 of 7 October 2016 laying down implementing technical standards with regard to the mapping of credit assessments of external credit assessment institutions for credit risk in accordance with Articles 136(1) and 136(3) of Regulation (EU) No 575/2013 of the European Parliament and of the Council".
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