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Downgrade Risk

Bonds

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Downgrade Risk is the risk a firm’s credit rating will fall after you’ve purchased their bonds. This lowers the value of any debt obligation issued at higher credit ratings. Bonds at lower ratings incur more risk and must pay a premium exceeding greater levels. They will be bypassed in the market if they don’t pay higher interest payments than lower risk bonds. Bonds issued before a downgrade will pay less interest than freshly issued debt obligations while having identical amounts of risk. Investors will skip elder bonds for those issued at the new credit rating, which provide higher interest rates to compensate for the same risk.

Note that downgrade risk has magnified effects when selling bonds. Downgrade risk will not adjust your interest rate or original par value. It does change the amount of risk you face. A lower credit rating means your bond’s issuer has increased their likelihood of defaulting. You are receiving higher risk but your reward compensates for a lower (and irrelevant) level of danger.

If downgraded multiple times the effects increase. The price will drop steeper than before, and you will be receiving more risk while missing out on more potential return in exchange. This can reverse if the firm is upgraded, but repeated upgrades do not normally follow a single downgrade. They follow a multiple level downgrade even less.

This also works in reverse. If you own bonds and their issuer’s credit rating is upgraded, the bonds will increase in value. The bond gives higher return for the same risk as the bonds the firm is issuing. There is a problem: If those bonds are callable, they are more likely to be called in. The upgraded rating means the issuer can pay cheaper interest rates than they were paying. They may simply call in the bond, give you your principal, and issue new bonds at lower payment rates.

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