How Credit Rating Risk Affects Corporate Bonds

How Credit Rating Risk Affects Corporate Bonds

According to the SEC (2013) the key risks of corporate bonds are default risk (also referred to as credit risk), interest rate risk, economic risk, liquidity risk and other significant risks including call and event risk. The higher default risk is the chief reason that speculative-grade bond issuers have to pay higher interest rates that go hand-in-hand with the so-called credit migration risk (or credit rating risk), which is part of the credit risk by extension. Credit-ratings, provided by rating agencies such as S&P and Moody's, are meant to capture and categorize credit risk.

According to Rebel (2009) credit migration risk describes the risk of “the potential for direct loss due to internal/ external ratings downgrade or upgrade as well as the potential indirect losses that may arise from a credit migration event”, also referred to as credit-rating risk or downgrade risk.

Key Takeaways

  • Credit risk is the potential loss to investors due to the issuer of a security being unable to repay all or part of its interest or principal due.
  • The greater the credit risk on an investment, the higher the yield investors demand to compensate for it.
  • Credit ratings are issued by ratings agencies and can be determined by calculating the probability of a default or other credit event.

Credit Risk and Investor Perception

The key here is what investors perceive. For example, many times when a corporate bond has its credit rating lowered, its price will go down as well. The reality is, however, that it’s not the credit rating going down that directly lowers the price. Instead, it’s the perceived value of that bond in the minds of investors that is responsible for the price drop. So there is more to it than simply the credit rating as that is only one of the things investors take into account when determining the price of a corporate bond. This also means that the price of a bond can also go down before an interest rate drop. The price of a bond can also decline because of other investor concerns. Likewise, any raise in the interest rate of a bond may also lead to the bond’s price going up.

This means that the proper procedure upon the downgrading of a bond is for investors to investigate what has caused this drop to see if these issues are short-term issues or if they are long-term issues. Additionally, investors should also evaluate their risk tolerance when considering the change in interest rate on a bond to determine if a new investment strategy would be a wiser option.

Credit Risk Migration and Default Probabilities

The credit risk for an issuer is determined by the probability of default over a given period. According to BBMMS (2010), credit migration refers specifically to the moving of a security issuer from one class of risk into a new one. For example, going into default would be a migration state. However, this is a special class of migration, an absorbing class or risk. That’s because when default occurs, there is an amount of loss which is what is at risk minus any possible recovery.

Unlike credit migration to default, determining the value of other migrations works a bit differently. The probability of any such migration is determined through the examination of historical data. A significant difference between default and other such migrations is that other risk states do not automatically trigger a loss of value for securities the firm issues. Instead, what happens is their probability of default is changed based upon this new historical data. So market-to-market transactions give value to such migrations because of the effect on flow rates in the future that will depend on the credit spreads, which vary from credit state to credit state.

The historical data here tells investors the frequency of defaults depending on how they wish to stipulate the term. A ratings agency can also provide the historical frequency of payment defaults over 90 days. In fact, some banks and agencies even keep default histories of any bankruptcy or missed payments. Such historical data is only somewhat useful to investors, however, because it does not let them know what default rates they should expect.

Credit Ratings

One common procedure that can be used here is mapping the frequencies of defaults with ratings from agencies. Keep in mind; however, that such ratings are in no way a direct measure of the probability of default. What agencies rate is not a securities issuer’s credit standing, but instead the quality of their risk. This quality of risk is stipulated as the severity of possible losses which encompasses both the chance of default and what would be recovered if the default does occur. This means that a particular issue’s rating does not always correspond exactly with the ratings and default probabilities of the firm that issued it. There is, however, a correlation between the historical frequency of defaults and both the issue and the issuer’s ratings. Many banks will even determine scores internally and map them along with agency ratings to determine default frequencies on their own.

Various sources confirm that credit rating migration has to play an integral part in the more general field of credit risk assessment of corporate bonds. The information in previous credit risk literature has therefore increased over the last years. There is substantial information on migration risk and default with specific focuses on different investor concerns about them. One might focus on simply an overview of all historical data. Another could use statistical techniques like the Credit Metrics by J.P. Morgan (first published in 1997) or RiskCalc, et cetera to focus on modeling techniques for the probabilities of defaults or ratings.

The Bottom Line

Credit migration risk is an essential part of the credit risk assessment in general. Credit migration risk analysis is a fundamental technique in Credit Metrics as well as other credit-VaR models. The study by Nickell et al. confirmed in 2007 that this type of framework measuring the credit risk associated with portfolios of defaultable securities has the potential to revolutionize the credit risk management and its measurement techniques.