How Credit Rating Risk Affects Corporate Bonds

One of the key risks for corporate bonds is credit risk, or the possibility that a borrower will be unable to repay its obligations on schedule. 澳洲幸运5官方开奖结果体彩网:Credit ratings, provided by🅰 rating agencies such as S&P and Moody's, are 🎐meant to capture and categorize credit risk.

Credit migration risk is the risk that a borrower may have their rating downgraded by a rating agency. When a 澳洲幸运5官方开奖结果体彩网:downgrade occurs, the yield premium will rise and the market price of the bond will fall. With the lower bo൩nd price, the holder would lose money if ൲they sell the asset before maturity.

Credit Risk and Investor Perception

The key here is what investors perceive. When the rating of a 澳洲幸运5官方开奖结果体彩网:corporate bond falls, its price༒ in the secondary markets tends to fall as well. The lower credit rating does not directly change the price; instead, the price drop is due to the change in investors' perceptions of the bond's value.

Beyond credit ratings, other factors also affect the price of corporate bonds. When interes🐻t rates drop, bond prices rise, because existing bonds will be paying higher rates than new ones issued at lower rates. Conversely, when interest rates rise, existing bonds will lose value, because new ones will pay higher rates.

This means that when a bond is downgraded, investors should investigate what caused this drop to see if these issues are short-term or long-term issues. Investors should also evaluate their 澳洲幸运5官方开奖结果体彩网:risk tolerance when considering possible changes in interest rates. A broad change in market-wide interest rates could warrant a shift in 澳洲幸运5官方开奖结果体彩网:investment strategy. Every investor is different and must consider their own goal🍌s and risk tolerance when making decisions.

Credit Risk Migration and Default Probabilities

Credit migration risk, also known as downgrade risk, is the risk of the bond losing value due to a downgrade of the issuer's credit rating. A downgrade typically causes bonds to lose value as investors now consider the asset to be more risky. They would expect a higher interest rate in order to accept such risk.

Since bonds have fixed interest rates, the market value of the downgraded bonds would drop, leaving current bondholders with an unrealized loss. However, they would only lose money if they sold the bond before maturity. In the event of default, bondholders would likely recover some of the losses. This is factored into risk anal🐭ysis and sophisticated investors' valuation of bonds.

Determining the risk of a credit rating downgrade is trickier than calculating default risk. The probability of a ratings drop is determined by the bond issuer's financial health, and by data from other companies and historical defaults.

A negative migration only triggers unrealized losses for bondholders, as the market value of the bond falls. However, until a default actually occurs, the bondholders continue to receive the expected payments. So the pricing of 澳洲幸运5官方开奖结果体彩网:market-to-market transactions is altered by such migrations bec🗹ause the bond's risk level has changed.

Credit ratings agencies do extensive research and analysis on bond issuers to determine their credit crating. This analysis involves examining the finan🉐cial health of bond issuers and determining the probability that they can and will continue to make payments to those holding their bonds.

Credit Ratings

One common procedure that can be used here is mapping the frequencies of defaults with ratings from agencies. According to Standard & Poor's, commonly known as S&P, one of the three main ratings agencies, credit ratings "provide a common and transparent global language for investors to form a view on and compare the relative likelihood of whether an issuer may repay its debts on time and in full." Thusly, a bond issuer's credit rating reflects the 澳洲幸运5官方开奖结果体彩网:probability that they will default or not default. Historically, there exists a correlation between the frequency of default and credit rating.

Various sources confirm that credit rating migration has to play an integral part in the more general field of 澳洲幸运5官方开奖结果体彩网:credit risk assessment of 澳洲幸运5官方开奖结果体彩网:corporate bonds. The information in previous credit risk literature has t♒herefore increased over the last years. 

There is substantial information on migration risk and default with specific focuses on different investor concerns about them. One might focus on simply an overview of all historical data. Another option is to use statistical techniques like Credit Metrics, originally published by J.P. Morgan in 1997 and now by RiskMetrics, or RiskCalc by Moody's to take advantage of expert modeling techniques for the probabilities of defaults or ratings.

The Bottom Line

Credit migration risk is an essential part of the credit risk assessment in general. Credit migration risk analysis is a fundamental technique in Credit Metrics as well as other credit-VaR models. Even if a borrower does not default, borrowers need to understand the risk of a downgrade to assess the value of a bond against other debt𝄹 instruments.