A Lower Rating Usually Means a Lower Price

When a credit rating agency downgrades a bond, it is saying the issuer is now more likely to miss interest or principal payments. Investors respond by demanding a higher yield to hold the bond, and because the bond’s coupon is fixed, the only way its yield can rise is for its price to fall.

The issuer still owes exactly the same interest and principal as before. A downgrade does not change the bond’s terms, only the market’s view of how likely the issuer is to honour them.

The most damaging downgrade is the one that drops a bond from investment grade to high yield, because many institutional investors are not allowed to hold high yield bonds and may be forced to sell. For the full route from the exam to a career advising on these situations, our complete guide to how to become an investment adviser representative covers every step.

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How Credit Ratings Work

A credit rating is an opinion from a rating agency on an issuer’s ability and willingness to meet its debt obligations. The three largest agencies are S&P Global Ratings, Moody’s and Fitch, and each uses a letter scale.

S&P and Fitch use AAA, AA, A and BBB for investment grade, and BB, B, CCC, CC, C and D below that, with plus and minus signs for finer steps. Moody’s uses Aaa, Aa, A and Baa for investment grade, then Ba, B, Caa, Ca and C, with the numbers 1, 2 and 3 for finer steps.

The dividing line sits between BBB minus and BB plus at S&P and Fitch, and between Baa3 and Ba1 at Moody’s. The Series 65 Exam Preparation course at FRC covers the rating scales and the investment grade cut-off, which the exam tests directly.

Outlooks, Watches and the Path to a Downgrade

Downgrades rarely come without warning. Agencies often first change a rating’s outlook to negative, which signals a possible downgrade over the next one to two years, or place the rating on watch for a possible downgrade, which usually signals a decision within a few months.

Markets often move before the agencies do. Bond prices and credit spreads tend to react as soon as investors see the issuer’s finances weakening, so by the time a downgrade is announced, much of the price fall may already have happened.

Common triggers include falling profits, rising debt, a large debt-funded acquisition, the loss of a major customer, or wider problems in the issuer’s industry or country. For governments and municipalities, budget deficits, falling tax revenues and pension shortfalls are frequent causes.

Ratings Before and After the Investment Grade Line

What Happens to the Price

A bond’s yield is made up of the yield on a comparable Treasury plus a credit spread that compensates for default risk. A downgrade usually widens the credit spread, pushing up the bond’s yield and pushing down its price.

Worked example: a ten-year corporate bond pays a 5 percent coupon and trades at $1,000, with a credit spread of 1.5 percentage points. It is downgraded from A to BBB, and its spread widens by 0.6 percentage points.

Step one: the bond’s yield rises from 5 percent to about 5.6 percent. Step two: with a duration of 7.5, the price falls by roughly 7.5 times 0.6, or about 4.5 percent. Step three: the bond’s price drops from $1,000 to about $955, although the issuer still owes the same $50 a year and $1,000 at maturity.

Fallen Angels and Forced Selling

A fallen angel is a bond that has been downgraded from investment grade to high yield. These downgrades often cause much larger price falls than downgrades within either category, because the pool of buyers suddenly shrinks.

Many insurance companies, pension funds, bank portfolios and investment-grade bond funds are restricted, by regulation or by their own mandates, to investment grade bonds. When a bond becomes a fallen angel, some of them must sell, often at the same time, which can push the price below what the issuer’s credit quality alone would justify.

Worked example: a bond with a duration of 6 is cut from BBB minus to BB plus, and its spread widens by 1.5 percentage points. Step one: the price falls by roughly 6 times 1.5, or about 9 percent. Step two: a $100,000 holding drops to about $91,000 almost overnight; our comparison of investment grade vs high yield bonds explains why the two markets price risk so differently.

Study Fixed Income With FRC

Bond questions on the exam often combine ratings, yields and prices in a single scenario, such as a downgrade followed by a question about what happens to the bond’s price or current yield. Our Series 65 course builds those connections step by step, with practice questions throughout.

Consider studying with FRC for every exam on your route. Explore our USA exam courses, from the SIE through the Series 7, Series 63 and Series 65.

To take advantage of the membership, explore FRC Professional Membership, which gives you a verified Digital Profile that shows employers your real-time course progress, together with the Video Resume. Current offers are on our membership deals page.

Current Yield After a Downgrade

Current yield is a bond’s annual coupon divided by its market price, and it moves in the opposite direction to price. When a downgrade pushes the price down, the current yield rises, even though the coupon itself has not changed.

Worked example: a bond with a $50 annual coupon trades at $1,000, giving a current yield of 5 percent. Step one: after a downgrade, its price falls to $900. Step two: the current yield becomes $50 divided by $900, or about 5.56 percent.

A new buyer at $900 receives the same $50 a year and, if the issuer pays in full, a $100 gain at maturity. That higher return is the market’s compensation for the extra credit risk the buyer is taking on.

Downgrades in the Municipal Bond Market

Municipal issuers are downgraded too, usually because of weaker tax revenues, rising pension costs or a shrinking local economy. Defaults among highly rated municipal bonds have historically been rare, but downgrades can still reduce prices and liquidity for investors who need to sell.

Some municipal bonds carry insurance from a bond insurer, which promises to pay interest and principal if the issuer cannot. An insured bond’s rating usually reflects the higher of the issuer’s own rating and the insurer’s, so if the insurer itself is downgraded, the bond can be downgraded even though nothing has changed at the issuer.

What a Downgrade Means for the Issuer

A downgrade raises the cost of borrowing for the issuer, because any new bonds it sells must offer higher yields. That extra cost can weaken the issuer’s finances further, which is one reason one downgrade is sometimes followed by another.

Some bonds and loans include clauses that are triggered by a downgrade. A coupon step-up raises the interest rate if the rating falls below a set level, and some agreements require the borrower to post collateral or repay debt early.

For companies near the investment grade line, keeping that status can be a priority. Management teams may cut dividends, sell assets or reduce borrowing to protect the rating, which bondholders generally welcome.

What a Downgrade Means for Existing Bondholders

For an investor who plans to hold a bond to maturity, a downgrade does not change the payments promised. If the issuer does not default, the investor still receives every coupon and the full face value at maturity, regardless of what happens to the price in between.

The risk that has changed is the chance of default. A higher chance of default means a higher chance that the investor will not receive all the promised payments, and if default happens, recovery depends on where the bond ranks in the issuer’s capital structure, as covered in our comparison of senior loans vs high yield bonds.

For an investor who may need to sell before maturity, the price fall is a real loss. That is why a downgrade can matter much more to a client who relies on the bond for liquidity than to one who will hold it to the end.

Upgrades Work in Reverse

When an issuer’s finances improve, an agency may upgrade its rating. The credit spread usually narrows, the yield falls and the price rises, so existing holders gain.

A rising star is a bond upgraded from high yield to investment grade, the opposite of a fallen angel. Rising stars can attract a wave of new buyers who were previously not allowed to own them, lifting prices.

Investors who identify improving credits before the agencies act can earn strong returns. That is one way active bond managers try to add value over an index.

The Limits of Credit Ratings

Ratings are opinions, not guarantees, and they can be wrong. Before the 2008 financial crisis, many mortgage-backed securities rated AAA suffered heavy losses, which led to criticism of how ratings were assigned.

Most rating agencies are paid by the issuers whose bonds they rate, which creates a potential conflict of interest. Agencies registered with the SEC as nationally recognized statistical rating organizations are subject to SEC oversight, including rules on conflicts and disclosure introduced after the crisis.

Ratings also tend to change slowly. Advisers therefore treat them as one input alongside the issuer’s financial statements, bond prices and market spreads, rather than as the final word on credit quality.

How Advisers Respond to a Downgrade

When a client’s bond is downgraded, the adviser should first check whether the bond still fits the client’s objectives and risk tolerance. A conservative client who required investment grade bonds may no longer be suitably invested in a fallen angel.

Selling immediately is not always right. If forced selling has pushed the price below fair value, holding the bond, or selling gradually, may serve the client better than selling into a falling market.

Diversification limits the damage from any single downgrade. Spreading bond holdings across many issuers and industries, or using diversified bond funds, keeps the effect of one issuer’s problems small, as explained in our article on systematic vs unsystematic risk.

The Memory Aid

Remember “rating down, price down, yield up”: a downgrade lowers the price and raises the yield, because the coupon is fixed.

For the investment grade line, remember “triple B minus or Baa3 is the last stop”: anything below BBB minus at S&P and Fitch, or Baa3 at Moody’s, is high yield.

For the most damaging downgrade, remember “angels fall hardest”: a fallen angel’s price usually drops more because the pool of buyers shrinks.

Exam Traps to Avoid

The first trap is assuming a downgrade changes the coupon or the principal owed. The bond’s terms stay the same unless it has a step-up clause; only its price and yield change.

The second trap is saying a downgrade lowers the yield. Yield and price move in opposite directions, so a lower price means a higher yield.

The third trap is placing BBB bonds in the high yield category. BBB, including BBB minus, is still investment grade. The fourth trap is treating a rating as a guarantee; ratings are opinions and can change or prove wrong.

A Client Scenario

A retired client holds $300,000 in individual corporate bonds, all rated investment grade when they were bought. One holding, worth $40,000, has just been downgraded from BBB minus to BB plus, and its price has fallen 10 percent.

The adviser reviews the issuer’s finances and finds the company is still profitable and well able to cover its interest, so the risk of default remains modest. The client’s investment policy, however, specifies investment grade bonds only, because she relies on them for steady income and may need to sell some in the next few years.

The adviser discusses the options with the client: selling now, selling gradually over several months to avoid the worst of the forced selling, or updating her policy to allow a small high yield allocation. She chooses a gradual sale, and the adviser documents the discussion, the analysis and how the decision fits her objectives.

The Dictionary as a Video Library

The FRC dictionary is a study tool, not just a glossary. Every entry pairs a written explanation with deep-dive video, on-page quizzes and interactive flash cards, so you can read a concept, watch it explained and test yourself in one place.

Rules are covered in the same depth: open a rule and you will find the full explanation alongside video walk-throughs of how it applies in practice. Open the credit rating entry to see the rating scales explained on video and test yourself with the quizzes.

Practice Questions to Test Yourself

Question one: A bond is downgraded from A to BBB. What usually happens to its price and yield? Its price falls and its yield rises.

Question two: What is the lowest S&P rating that is still investment grade? BBB minus.

Question three: What is a fallen angel? A bond downgraded from investment grade to high yield.

Question four: A bond with a duration of 8 sees its credit spread widen by 0.5 percentage points after a downgrade. Roughly how much does its price fall? About 4 percent.

Question five: An investor holds a downgraded bond to maturity and the issuer does not default. What does she receive? Every remaining coupon and the full face value at maturity.

Turn Fixed Income Knowledge Into Career Evidence

Bond markets reward advisers who can explain credit risk calmly when headlines turn alarming. FRC’s Digital Profile shows employers the courses you are actively studying and the progress you have earned through assessed learning, verified by FRC, and a QR code on your resume takes them straight to it.

The FRC Video Resume lets a hiring manager hear you before the interview. Walking through how you would handle a client’s fallen angel bond shows the judgment that fixed income and advisory teams look for.

Related Questions

Municipal bond buyers find an issuer’s rating, and the factors behind it, in the bond’s offering document, as explained in Official Statement vs Prospectus. Rating changes after issue are disclosed as event notices, which investors can find on the MSRB’s EMMA website.

Key Points to Retain

A downgrade signals a higher chance of default, so investors demand a higher yield, and because the coupon is fixed, the bond’s price falls. The bond’s terms do not change, and an investor who holds to maturity still receives all payments if the issuer does not default.

The investment grade line sits at BBB minus for S&P and Fitch and Baa3 for Moody’s, and a fallen angel that crosses it can suffer a much larger price fall because of forced selling. Ratings are opinions that can lag the market, so advisers combine them with their own analysis and respond to downgrades based on each client’s objectives.

For the role the exam leads to, read our guide to what an investment advisor representative is.