Rating agencies (Standard & Poors, Moody's, Fitch and the like) got a bad press at time of the sub-prime lending debacle. But whatever the rights and wrongs of that particular issue, the rating categories themselves are eminently logical.

Bond ratings are combinations of letters that indicate the creditworthiness of a bond issuer and, by implication, the bonds themselves. The letters are often taken to provide an indication of the likelihood of a default. Default is a bond issuer failing to pay interest on a bond on time and in full, or failing to repay capital on the bond's redemption date.

There is plenty of data available on the percentage of defaults for each 'notch' of the ratings spectrum at extreme low points in past economic cycles. But default rates vary a lot from year to year so historical data of this sort does not necessarily indicate the probability of default in any true statistical sense.

The premium on which bond yields stand over supposedly risk-free sovereign debt of similar maturity (for example US Treasuries, UK gilts or German bunds) gets higher as one moves down the ratings spectrum.

But what do the ratings mean? Here's a quick summary that shows it fairly clearly:

• AAA: capacity to meet obligations is 'very strong'.
• AA: differs from AAA only slightly.
• A: more susceptible to changes in conditions; 'strong' rather than 'very strong'.
• BBB: likely to be affected to changes in condition but protection 'adequate'.
• BB: uncertainties may mean inadequate capability of meeting commitments.
• B: uncertainties are likely to impair ability to meet commitments.
• CCC: vulnerable to non-payment unless conditions improve.
• CC: highly vulnerable to non-payment.
• C: currently paying, but default highly likely.
• D: in default.
• NR: not rated, or insufficient information.

This is based on S&P ratings. Fitch uses a similar convention. Moody's uses a slightly different convention, mixing upper and lower-case letters and numbers. All three generally convey a similar message. It's also worth remembering that there are sub-divisions within these broad categories that have slightly different meanings.

Bonds are reckoned to be 'investment grade' if they are BBB- (S&P and Fitch) or Baa3 (Moody's) or better. Recent historical data suggests that default rates increase sharply as rating notches decrease below the 'B' grade and are very high for CCC and below. Bonds with ratings in this category had a median default rate of 18 per cent in the 30 years to 2008. The highest percentage default rate for any single year over the same period was 57 per cent and the lowest 0 per cent.

As of end November 2011, Sweden, Switzerland, the UK, the Netherlands, Germany and France, among others, all had AAA ratings. Greece's rating was C. Greece's rating is reflected in bond yields nearly 32 percentage points higher than Germany's.

The prize for the highest yield on US dollar bonds issued by a sovereign government probably goes to Argentina, whose five-year bonds currently yield 42 percentage points more than US Treasuries. Any restructuring of the eurozone is likely to lead to a marked reassessment of creditworthiness of individual governments' bond issues.

Nonetheless, the European Central Bank has received take-up of a massive €489 billion (£408 billion) of three-year loans to eurozone banks at negligible rates of interest. In what is known as a 'carry trade', the theory calls for the banks to use the money to buy, and thereby bolster, the prices of eurozone government debt (and pocket the yield premium available, but banks may instead just use the money to bolster their balance sheets in other ways).

While Spanish banks, for example, may buy Spanish debt, and French banks French government debt, it remains to be seen how much cross-border bond buying there will be. Most eurozone banks, and their shareholders, want less exposure to the eurozone rather than more.

This was written for our sister website, Interactive Investor