How Credit Rating Risk Affects Corporate Bonds
The primary risks of corporate bonds, according to the SEC (2013), include default risk (also known as credit risk), interest rate risk, economic risk, liquidity risk, and other important risks such as call and event risk. The increased default risk is the primary reason why speculative-grade bond issuers must pay higher interest rates, which are linked to the so-called credit migration risk (or credit rating risk), which is part of the credit risk by extension. Credit ratings, such as those offered by S&P and Moody’s, are intended to quantify and classify credit risk.
Credit migration risk, also known as credit-rating risk or downgrade risk, is defined by Rebel (2009) as “the potential for direct loss due to internal/external ratings downgrade or upgrade as well as the possible indirect losses that may emerge from a credit migration event.”
- Credit risk is the possibility of a loss to investors if the issuer of a security is unable to repay all or a portion of the interest or principal due.
- The bigger the credit risk on an investment, the higher the return required to compensate.
- Rating agencies give credit ratings, which are calculated by evaluating the likelihood of a default or other financial event.
Credit Risk and Investor Perception
The important here is how investors interpret things. For example, when a corporate bond’s credit rating is reduced, the price of the bond falls as well. However, it is not the credit rating deterioration that immediately affects the price. Instead, it is the bond’s perceived worth in the eyes of investors that is causing the price reduction. So there’s more to it than just the credit rating, since that’s just one of the factors investors consider when calculating the price of a corporate bond. This also implies that the price of a bond might fall before interest rates fall. Other investor worries might also cause a bond’s price to fall. Similarly, any increase in a bond’s interest rate may cause the bond’s price to rise.
This implies that when a bond’s rating is downgraded, investors should research what caused the reduction to determine if the concerns are short-term or long-term. Additionally, while contemplating the change in interest rate on a bond, investors should analyze their risk tolerance to see whether a new investing plan would be a better alternative.
Credit Risk Migration and Default Probabilities
The chance of default over a particular time determines an issuer’s credit risk. According to BBMMS (2010), credit migration is the movement of a security issuer from one risk class to another. Going into default, for example, would be a migration status. However, this is a distinct kind of migration, a risk-absorbing class. This is due to the fact that when a default happens, there is an amount of loss that is at risk, less any probable recovery.
Unlike credit migration to default, assessing the value of other migrations is a little more complicated. The likelihood of any such migration is calculated by examining past data. The fact that other risk situations do not invariably result in a loss of value for shares issued by the company distinguishes default from other such movements. Instead, their default likelihood is altered as a result of this new historical data. So market-to-market transactions add value to such migrations because of the future influence on flow rates, which will be determined by credit spreads, which vary from credit state to credit state.
The historical data shown here informs investors about the frequency of defaults according on how the term is specified. A ratings agency may also give information on the historical frequency of payment failures that exceed 90 days. In reality, several banks and government organizations maintain track of any bankruptcy or missing payments. However, such historical data is only marginally relevant to investors since it does not tell them what default rates to anticipate.
Mapping the frequency of defaults with agency ratings is a typical approach that might be applied here. However, keep in mind that such ratings are not a direct indication of the likelihood of default. What agencies evaluate is not the creditworthiness of a securities issuer, but rather the quality of their risk. This risk quality is defined as the severity of probable losses, which includes both the possibility of default and what would be recovered if the default occurs. This implies that a given issue’s rating does not always coincide perfectly with the firm’s ratings and default probability. However, there is a link between the historical frequency of defaults and the ratings of both the issuance and the issuer. Many banks may even calculate their own scores and overlay them alongside agency ratings to establish default frequency.
Various sources indicate that credit rating migration must play an important role in the broader area of corporate bond credit risk assessment. As a result, the material in earlier credit risk literature has grown in recent years. There is a wealth of material available on migration risk and default, with special emphasis on various investor concerns. One might just concentrate on an overview of all previous data. Another option is to employ statistical approaches such as J.P. Morgan’s Credit Metrics (first published in 1997) or RiskCalc, among others, to concentrate on modeling methodologies for the likelihood of defaults or ratings.
The Bottom Line
Credit migration risk is an important component of credit risk assessment in general. Credit migration risk analysis is a key approach in Credit Metrics and other credit-VaR models. Nickell et alresearch .’s from 2007 indicated that this sort of methodology for quantifying credit risk linked with portfolios of defaultable securities has the potential to revolutionize credit risk management and assessment methodologies.
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