Most individual bonds – including the majority of those typically held in bond funds-- are assigned credit ratings by major rating agencies, such as Standard & Poor's. When a rating agency raises a bond’s rating, this action is called an “upgrade.” Similarly, a lowered rating is called a “downgrade.” Upgrades and downgrades can be key drivers of bond performance.
Performance Factors Leading to a Downgrade
Agencies base their bond ratings on several factors, one of the most important being the risk of default, the issuer's failure to make scheduled interest and principal payments. Other factors that the rating agencies consider are:
- A deterioration in the issuer’s balance sheet, such as falling cash balances or rising debt
- The issuer's declining ability to service its debt with cash remaining from revenues after expenses have been deducted
- Other deteriorating business conditions – a corporation's falling profit margins and earnings growth among them – or for a government issuer, weaker economic growth
- A deteriorating outlook: A corporation, for instance, with major revenue from desk phone sales or an energy corporation invested in coal mines. For a government, the deteriorating outlook could be a second recession before the country's full recovery from an earlier recession.
Performance Factors Leading to an Upgrade
Factors leading to an upgrade include:
- An improvement in the issuer’s balance sheet, such as a growing cash balance or falling debt.
- An improving ability of the issuer to service its debt via the cash left over after expenses are subtracted from revenues.
- Improving business conditions – including rising profit margins and earnings growth for a corporation, or for a government issuer, an improving economy.
- A better outlook for the issuer, including the potential impact of changes to industry trends, the issuer’s regulatory environment, or its ability to withstand economic adversity.
The Impact of Upgrades and Downgrades on Performance
The prices of individual bonds typically respond to upgrades and downgrades or, quite often, to the anticipation of an upgrade or downgrade. For most bonds, credit risk – or changes that make it more or less likely to default – is a key element of performance. When a bond is upgraded, investors are willing to pay a higher price and accept a lower yield. When a bond is downgraded, the opposite is true. (Keep in mind, prices and yields move in opposite directions.)
It’s important to remember that the market often moves ahead of an upgrade or downgrade in anticipation of such an event. As a result, the announcement of a rating change may not necessarily lead to a significant impact on performance in the days and weeks following the announcement -- the market has already reacted to the official announcement.
Broader trends in upgrades and downgrades can affect an entire market. Bond market segments whose performance is dictated more by credit risk than interest rate risk – particularly lower-rated investment-grade corporate bonds and high yield bonds – tend to benefit when the ratio of upgrades to downgrades is high or rising, and exhibit weaker performance when the ratio is low or falling.
Example of a Rating Change
This news item from flyonthewall.com, released in March 2013, describes a rating downgrade suffered by J.C. Penney, and helps illustrate how both current conditions and the future outlook play a part:
“Standard & Poor's Ratings Services announced it lowered its corporate credit rating on J.C. Penney to "CCC+" from ‘B-.’ The outlook is negative, S&P said. S&P added, "The downgrade reflects the performance erosion that has accelerated throughout the previous year and seems likely to persist over the next 12 months...It also reflects our assessment that the company's liquidity position is 'less than adequate' and that J.C. Penney will need to seek additional financing or borrow substantially on its revolving credit facility to continue its transformation.”