Downgrade risk

A bond can lose money without the issuer defaulting on anything.

Ratings agencies review issuers continuously. If a company's financials deteriorate, its rating is cut — and every bond it has already issued reprices immediately, because the market now demands a higher yield for that same paper. The holder took no new decision and received every coupon on time, and is still poorer.

The workbook places this as one of three types of credit risk: downgrade risk, spread risk and default risk. Default is the one investors think about. Downgrade is the one that actually shows up in a portfolio valuation.

Two effects, one event. When a company's credit rating is downgraded on account of deterioration in its financials:

1. the issuing company faces a higher cost for raising new resources — future borrowing gets dearer; and
2. existing bondholders face a drop in the price of their bonds, because the cost of funds for that company has risen in the market.

The second is the investor's problem. Price and yield move inversely, so a wider required spread means a lower price, and the size of the fall depends on how long the bond has left to run — a downgrade hurts a ten-year bond far more than a one-year bond.

Why it cascades. The workbook's example is the IL&FS case of August-September 2018, which it describes as a cascading effect of rating downgrades. A downgrade below a threshold can force funds whose mandates require investment-grade paper to sell, the selling pushes prices lower, and the lower prices trigger further stress. Nothing in that sequence requires an actual default.

Its siblings. Spread risk is the risk that the spread a non-government bond pays over comparable government securities widens dynamically with market conditions, even with no rating action. Default risk is the failure to pay. The three sit on a continuum, and downgrade risk is the middle one.

An investor holds Rs 50,00,000 face value of a corporate bond with 4 years left, rated AA, bought at par to yield 8.20% — a spread of 120 basis points over the 7.00% government security of the same maturity.

The issuer is downgraded to A. The market now demands a spread of 270 basis points, so the required yield becomes 9.70% — a widening of 150 basis points.

Assume a modified duration of 3.4 years for a 4-year bond of this coupon:

Price change  = - modified duration x change in yield
              = - 3.4 x 1.50%
              = - 5.1%

Loss on Rs 50,00,000 = Rs 2,55,000

Rs 2.55 lakh, and every coupon is still being paid on the due date. The investor could hold to maturity and be repaid in full — but the portfolio is marked to market, and today it is worth Rs 47,45,000.

The same downgrade, two maturities:

Same issuer, same news, losses differing by a factor of seven. That is why an adviser who is uncertain about an issuer's credit shortens maturity rather than merely reducing the holding.

And on the issuer's side: its next Rs 500 crore of borrowing now costs 150 basis points more — Rs 7.5 crore a year of additional interest, which makes the financial deterioration that caused the downgrade worse. That is the cascade.

Chapter 9 (Investing in Fixed Income Securities), section 9.3.4.1, the first of the three credit risks set out at 9.3.4, with spread risk at 9.3.4.2 and default risk following. Expect a question asking you to name the three types of credit risk, and one testing whether a downgrade harms a bondholder who intends to hold to maturity.

• A downgrade is not a default. Every payment can be made on time and the holder still loses money on the price.
• It is credit risk, not interest rate risk. The workbook divides bond risk into market risk (from changes in the level of interest rates) and credit risk (from changes in the borrower's creditworthiness). A downgrade belongs to the second, even though it moves prices through a yield.
• The three credit risks are downgrade, spread and default. Listing only default is the most common incomplete answer.
• The issuer suffers too — a higher cost for raising new resources — which can deepen the problem that caused the downgrade.
• Longer maturity means a larger loss for the same downgrade. The rating action is identical; duration decides the damage.
• Government bonds are treated as risk free in this chapter and so carry no downgrade risk; PSU and bank paper sits between sovereign and pure corporate credit.
• IL&FS, August-September 2018 is the workbook's named illustration, and it is cited for the cascading nature of downgrades, not merely for the fall itself.