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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.

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    $\begingroup$ The credit risk scale is a bit like the eartquake scale: the difference between Richter 0 and 1 earthquake is tiny (barely detactable), but the differences become more and more pronounced as you go up. Richter 9 is enormously more damaging than Richter 8, absolutely catastrophic. Similarly for probability of default. These are not linear scales. $\endgroup$
    – nbbo2
    Commented May 28, 2022 at 17:26

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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.

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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.

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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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