Bond Investing For Dummies by Russell Wild

Author:Russell Wild [Wild, Russell]
Language: eng
Format: epub
ISBN: 9781119894803
Publisher: Wiley
Published: 2022-08-01T00:00:00+00:00

Downgrade risk

Even if a bond doesn’t go into default, rumors of a potential default can send a bond’s price into a spiral. When a major rating agency, such as Moody’s, Standard & Poor’s, or Fitch, changes the rating on a bond (moving it from, say, investment-grade to below investment-grade), fewer investors want that bond. This situation is the equivalent of Consumer Reports magazine pointing out that a particular brand of toaster oven is prone to explode. Not good.

Bonds that are downgraded may be downgraded a notch, or two notches, or three. The price of the bond drops accordingly. Typically, a downgrade from investment-grade to junk results in a rather large price drop because many institutions aren’t allowed to own anything below investment-grade. The market therefore deflates faster than a speared blowfish, and the beating to bondholders can be brutal.

On occasion, downgraded bonds — even those downgraded to junk, which are sometimes referred to as fallen angels — are upgraded again. In the rare case that happens, prices zoom right back up again. Holding tight, therefore, sometimes makes good sense.

But trust me when I tell you that bond ratings and bond prices don’t always march in synch. Consider, for example, that when US Treasuries were downgraded by Standard & Poor’s in 2011 from an AAA to an AA rating, the bonds didn’t drop in price but actually rose, and rose nicely. Why? In large part, it was because of the credit crisis in Europe and the realization of Japan’s rising debt. In other words, although the United States appeared to be a slightly riskier place to invest vis-à-vis other nations, it actually started to look safer.

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