Credit ratings for most individual bonds held by bond funds are issued by Standard & Poors and other major rating bodies. Standard & Poor's and other major rating organizations issue credit ratings to most individual bonds owned in bond funds.
An "upgrade" occurs when a credit rating agency raises a bond's rating. A similar term, "downgrade," describes a decline in a rating. Bond performance can be significantly affected by both upgrade and downgrade activity.
What's a Downgrade?
A downgrade occurs when an analyst at a financial services organization lowers their prediction for a stock's future performance. It is common practice for financial services companies to staff their businesses with analysts.
Their duties include researching and recommending to customers whether they should buy, hold, or sell a particular stock. If an analyst's rating drops from "buy" to "hold" or "hold" to "sell," the rating has been downgraded. The opposite of a downgrade is an upgrade.
Functioning of Downgrades
When making stock recommendations, analysts try to paint a broad picture of a stock's prospects for its clients and investors. When the rationale for the advice shifts, so make the recommendations. A significant announcement by the firm, an unexpected figure in its financial statements, or a news event with consequences for the company or industry might all lead to a downgrade or an upgrade.
How Do Stock Price Increases Work?
If an analyst raises a stock's rating from "sell" to "hold" or "hold" to "buy," it suggests the analyst now sees more significant potential in the stock and has grown more bullish on its price.
As the trading community pays close attention to the opinions of Wall Street analysts, a positive rating revision has a positive impact on share prices in the near term.
Possible explanations include increased demand for shares due to the upgrade and a subsequent price hike, as well as increased demand from the analyst's clientele.
Reasons For The Decline In Performance
Agencies weigh several criteria when assigning bond ratings, but default risk (the possibility that the issuer may not pay interest and principal as agreed upon) is a significant consideration. In addition to these primary considerations, rating agencies also look at the following:
- Declining cash reserves and increasing debt on the issuer's balance sheet
- The deterioration in the issuer's capacity to pay down debt using proceeds from operations
- Other worsening business conditions, such as a corporation's declining profit margins and profits growth, or for a government issuer, poorer economic growth
- A worsening prognosis: a company whose primary source of income is selling desk phones or a power company with holdings in coal mines.
Reasons Why Your Vehicle Needs an Upgrade in Performance
Causes of Improvement Can Be Found In:
- A strengthening of the issuer's financial position, as evidenced by a rise in liquid assets or a debt reduction.
- A rise in the issuer's capacity to pay interest and principal on its debt with funds remaining after paying necessary expenditures.
- A rise in corporate profit margins and profits growth, or, in the case of a government issuer, a surge in economic circumstances.
- An improvement in the issuer's prospects, such as in industry trends, the issuer's regulatory environment, or the issuer's capacity to weather economic storms.
Changing Performance Due to Upgrades and Downgrades
Upgrades and downgrades, or the expectation of either, frequently cause a reaction in the values of individual bonds. Credit risk, or fluctuations in the likelihood of default, is a significant factor in the performance of most cement.
Investors are more likely to purchase a bond at a higher price and tolerate a lower yield if it has been upgraded. In contrast, when a bond is downgraded, the inverse is true. Remember that the market tends to react to rumors of an impending upgrade or devaluation far before the event occurs.
Since the market has already responded to the formal release, a rating adjustment may not drastically affect performance in the days and weeks after the announcement.
Risk Of An Angel Falling
Bonds of any rating can suffer from a downgrade, but the value of a "fallen angel" may drop much worse. The term "fallen angel" refers to a corporate bond formerly rated as investment-grade but has now been demoted to the higher-risk junk category.
Since fewer buyers of high-yield bonds exist than investment-grade corporate bonds, fallen angels may endure even more significant price losses.
When a bond issuance is reduced to junk status, investors who can only invest in bonds rated "investment grade," such as many pension funds and mutual funds, are forced to sell.
