Why credit upgrades and downgrades affect bond returns

Credit ratings and bond returns

A ratings upgrade or downgrade has a direct impact on fixed income yields, and therefore directly affects bond prices. A ratings upgrade implies that the borrower’s credit risk profile has improved, which would reduce the required rate of return on its debt, thereby increasing its price. A ratings downgrade would imply the opposite.

Usually, the credit rating agency (or CRA) would put the issuer on a ratings watch prior to revising its credit rating. The ratings watch usually alerts investors to the change in the issuer’s circumstances and may result in most of the price appreciation or depreciation for the security taking place even before the revised rating is issued. This ensures bond market stability.

For example, on March 7, 2014, Moody’s placed its credit rating on Safeway Inc. (SWY) debt on review for a possible downgrade, after Safeway (SWY) agreed to be acquired in a leveraged buyout (or LBO) by Cerberus Capital Management in a $9 billion transaction. Moody’s believes the transaction will result in significantly higher financial leverage, which will affect the company’s ability to service about $4 billion of rated debt.

The impact of ratings revisions on high-yield fixed income securities High-yield bonds (HYG) are rated below investment-grade (below BBB- as per Standard & Poor’s ratings system or BB+ for Moody’s ratings system). Since they have high default risk, these bonds offer a higher yield and have relatively stronger correlations with stock markets (SPY) rather than bond markets (AGG), as credit spreads tend to narrow in an expansionary economic environment and expand when the economy contracts.

What are credit spreads?

Credit spreads are the differences in yield between two debt securities with differences in credit quality. A debt security with higher credit quality would sell at a higher price or a lower yield compared to a similar security of poorer credit quality. The difference in yields between the two securities is called the “credit spread.” The most common examples of credit spreads are between Treasury securities (TLT) and corporate bonds with similar characteristics apart from risk. Treasury securities (TLH) are considered the least-risk asset, and yields for other debt securities are often computed by adding a credit spread over the corresponding maturity Treasury yield.

The graph above shows stock market (SPY) and high-yield bond fund (HYG) price movements in 2013 and 2014. When credit ratings on these bonds are upgraded, these bonds would experience greater price increases due to narrowing spreads and vice versa when ratings are downgraded.

To read about the implications of the improving up/down ratio, read on to Part 6 of this series.