Downgrade risk affects both bond and equity investors. Different entities issue ratings for bonds and stocks. But the net effect of a downgrade is similar for both bonds and stocks. Investors who hold either of these investments are always exposed to downgrade risk. In this article, we’ll discuss what downgrade risk is.
Rating Agencies and Analysts
Where does downgrade risk come from? Bonds and equities are graded by rating agencies and stock analysts, respectively. Rating agencies focus on corporate and government bond quality. Equity analysts focus on the quality of stocks.
Each provides proprietary ratings. Ratings on bonds for a company can be different depending on the rating agency. It’s the same for stocks. There’s often a broad range of analyst ratings for a single stock. One analyst may have an underperform rating on a stock while another has an outperform.
Ratings on bonds and stocks can change for many reasons:
- Economic downturn
- Over-reliance on continued debt financing
- Slow down in growth
- Overall sector downgrade
In some cases, before a company’s bonds are downgraded, a rating agency will issue a ratings watch. This basically puts the company on probation and warns investors of heightened risk.
Some bonds are considered investment grade, while others are called junk. These terms depend on the specific scoring systems proprietary to each rating agency. Investment grade isn’t a subjective term. It has legal merit. Fiduciary institutions, such as banks, are required by law to limit their bond investments to only investment grade.
How Do Downgrades Affect Bonds and Equities?
Downgrades have a negative impact on both bonds and equities. It signals to the investors that the entity behind the bond or stock has weakened in some material way.
When a bond is downgraded, the company will have difficulty trying to issue new debt. To get around this problem, the company must raise its interest rate. Increasing the interest on new bonds helps offset some of the additional risks investors face.
A higher interest rate may bring in new investors, but it also increases the cost of capital. The company must pay more for debt financing. This can decrease overall margins and require cutbacks in operating expenses, staff layoffs, or termination of a new project. The trickle effects of higher debt costs can be devastating for some companies.
What does a bond downgrade mean for an investor who is holding a bond during the downgrade? The downgrade means the investor is now holding a riskier investment. The value of the bond will also go down as interest rates have now increased.
When a stock analyst downgrades a stock, the immediate impact can be a drop in the stock price. Obviously, that will affect an investor’s portfolio’s value. The downgrade can also cause some larger institutional investors to sell their holdings, causing the stock to decline further. If that isn’t enough, institutional investors that may have been considering the stock will probably take it off of their watchlist.
It can be difficult to know when a rating agency will downgrade a bond or when an analyst will downgrade a stock. How can investors protect themselves from downgrade risk? One method is diversification, which can lessen the negative impact of a single investment. There are many ways to diversify a portfolio, but all of them have the same objective — to limit the impact of volatility on a portfolio.
