If bonds are downgraded (that is, if the credit rating is lowered), the bond price declines. If the rating is upgraded, the price goes up. In fact, bond prices sometimes change if there is even a strong possibility of an upgrade or a downgrade. This is because anxious investors sell bonds whose credit quality is declining and buy bonds whose credit quality is improving.
Unless there is a genuine risk of default, however, price changes in response to upgrades or downgrades are far less major than those occurring due to changes in interest rate levels. With rare exceptions, ratings go up one notch or down one notch in the rating scale, and prices go up or down by perhaps 1% or 2% per bond in response to rating changes. The change in price corresponds to the amount necessary to bring the yield of a bond (and therefore its price) in line with other bonds rated at the same level. For bonds rated AA, for example, a downgrade to A+ may not make a noticeable difference in the price.
This point needs to be emphasized because many individual investors are needlessly worried about relatively minor downgrades and this fear is sometimes exacerbated by the financial press. For bonds that have very high credit quality (AA or AAA), a deterioration in the rating is not a major cause for concern. It would not result in a serious deterioration in the price of the bond. A more serious concern would be a series of downgrades, particularly if downgrades drop the credit rating to below investment grade.
There is one notable exception to the preceding statements. During the takeover craze of the 1980s, corporate bond prices were exceptionally volatile because of the possibility of downgrades due to takeovers.
Continue to Step 5 »
