When You Should be Concerned About a Credit Rating ChangeAugust 13th, 2012 by David Waring
Rating changes can be good or bad, meaning upgrades or downgrades. A credit rating upgrade may lead to an increase in a bond’s price and provides an indication that a company’s financial situation is improving. Most investors pay little attention to upgrades, but worry about downgrades. Downgrades can lower a bond’s price (particularly if the market is not expecting one) and can provide a sign that there is an increase in the probability of a bond’s default. (Learn what happens when a bond defaults here.)
How often do rating changes occur?
According to S&P data from 1981-2011, in a typical year there are rating changes for about 20% of issuers, with 8% being upgrades and 12% being downgrades. In addition to upgrades and downgrades, there are defacto rating changes in the form of defaults and withdrawn ratings. About 2% of bonds default per year and 7% of bonds have their ratings withdrawn. Add these numbers together, and there are rating changes on about 29% of all corporate issuers per year.
How severe is the typical downgrade?
A rating upgrade or downgrade of more than one letter grade is rare, for example from BBB to B or AA is unusual. (Don’t know about letting ratings? Go here) In 2011, no BBB rated bonds were upgraded to AA or better. Only 0.14% were downgraded to to B or worse. The overwhelming majority, 92.5%, of BBB rated bonds in 2011 (BBB+, BBB, BBB-) remained BBB even though a some of them did have a rating change.
Was 2011 a typical year for BBB rated corporate bonds? The average percentage of rating changes which altered the rating by more than one letter from 1981-2011 was much higher, but still a tad below 1%.
When should a rating change start causing concern?
If you own individual bonds, any rating change should provide a reason for re-evaluating the premise of the investment. If you are a conservative investor, you might have a rule that once a bond falls BBB or BBB- , you should liquidate. Those with a high risk tolerance might want to sell bonds before they hit around B+. A study by S&P of corporate bonds (for non-financial companies) fell to an average rating of B+ around 1 year before they defaulted, after which the decline of their ratings accelerated.
For financial companies, ratings crumble much quicker than non-financial companies. The same study showed a year before default the average rating stood between BB and BB+. In general, the ratings of financial companies have more rapid path downwards than non-financial companies. This is one of the main reasons, yields on bonds from financial companies pay a much higher interest rate than similarly rated non-financial companies (you can learn more about this here).
Some of the larger online brokers such as TD Ameritrade and Charles Schwab offer free email alerts which allow investors to track ratings changes on bonds they own or are considering investing in.