Outline how credit default swap spreads, bond prices and stock prices tend to move when a credit rating is upgraded or downgraded.
The idea
A downgrade raises the market's required return on the issuer's debt. Its CDS spread widens, its bond yield rises, its bond price falls, and its stock price tends to fall. An upgrade does the reverse. Let D be the bond's modified duration and Δy the change in its yield. The approximate percentage price change, as a fraction of the bond's price, is Change = −D × Δy. Reactions are asymmetric. Downgrades produce clear and significant negative reactions, whereas the reaction to upgrades is weaker and often not statistically significant. Markets also tend to anticipate rating changes, especially downgrades, since agencies move slowly and spreads and equity prices often move before the announcement. The surprise on the day is smaller when the downgrade was expected. On the exam, remember the direction of each variable, the asymmetry and the anticipation.
Formulas
Approximate bond price change after a rating change
price change % = −D × Δy
- D
- the bond's modified duration
- Δy
- the change in yield or credit spread, in decimals
A first-order estimate: for a large yield rise it overstates the price fall because of convexity. A downgrade widens the spread, so the sign is negative.
A practice question
Following a downgrade, the price of the issuer's existing bonds typically:
- falls, because the yield investors require increases. - correct
- rises, because the issuer must offer a higher coupon on new bonds.Why not: The coupon on existing bonds is fixed; a higher required yield lowers their price.
- is unchanged, because the bond's coupon and maturity are fixed.Why not: Fixed cash flows discounted at a higher required yield mean a lower present value.
- falls only if the bond matures within a year, because long bonds are protected.Why not: Longer-maturity bonds are more sensitive, not less, to changes in the required yield.
Higher credit risk raises the required yield, so the present value of fixed cash flows falls.
A harder one
A downgrade widens a bond's credit spread from 150 basis points to 250 basis points. The bond has a modified duration of 6. The approximate percentage price change is:
- -1.0%Why not: Applies the 100 basis point yield change directly, without multiplying by duration.
- -6.0% - correct
- -15.0%Why not: Multiplies duration by the new spread level (2.5%) rather than the change in spread (1.0%).
- +6.0%Why not: Has the correct magnitude but the wrong sign; wider spreads lower the price.
Price change is about -D x change in yield = -6 x 1.00% = -6.0%.
The hardest tier
An issuer's CDS spread widens by 80 basis points over the three months before the issuer is downgraded. On the announcement day the spread moves only slightly. The most reasonable interpretation is that:
- the downgrade was a surprise that the CDS market ignored, so CDS spreads are unreliable indicators of credit risk.Why not: Misreads the evidence: the earlier widening shows the market had priced the deterioration before the announcement.
- the CDS market had already anticipated the downgrade, so the announcement carried little new information. - correct
- the rating agency reacted to the CDS market by reducing its own estimate of default risk.Why not: A downgrade raises, not reduces, the agency's view of default risk.
- the downgrade will be reversed shortly, because the spread did not react on the day.Why not: A quiet announcement-day reaction does not imply a reversal; it implies the information was priced in.
CDS and bond markets tend to move ahead of agencies, especially for downgrades, so announcement-day reactions can be small. Ratings lag the market.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in External and Internal Credit Ratings
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