What to Consider When Your Bonds Get Downgraded - Butler Financial, LTD


What to Consider When Your Bonds Get Downgraded

Drew O’Neil discusses fixed income market conditions and offers insight for bond investors.

For anyone with an investment portfolio, these can be stressful times leaving us unsure of exactly what, if anything, to do and how to process the abundant news and data. The COVID-19 pandemic is causing disruption to the global economy in ways never thought possible leading everyone (individuals, corporations, governments, etc.) to take unprecedented measures that were likely never planned for or even considered. The short-term effects of these measures have been drastic while the long-term effects remain unknown.

The entire global economy is currently under stress due to the virus and the steps taken to try and contain it. Entire industries have virtually come to a halt, supply chains have been disrupted, municipalities are spending money on things they never planned for, the educational system has essentially be halted or moved online, public transit ridership is minimized, a large portion of the world’s population has been ordered to remain in their homes … the list goes on and on. As a result, many credits (both municipal and corporate) have already been or could soon see a downgrade to their credit ratings.

Credit rating downgrades in investor portfolios have (hopefully) been a fairly rare occurrence until now, so these downgrades are creating a lot of questions. These questions are generally along the lines of: Should I be worried? Should I sell? Why were they downgraded? How does this affect my portfolio? Will they be downgraded again? Are they going to default? The answer to these questions is going to be different for each issuer and each investor, therefore, let’s highlight some helpful ways to think about credit downgrades instead of just knee-jerk reacting and immediately selling a bond that still might be a perfect fit for your portfolio.

Things to consider when something gets downgraded:

  • What is the new credit rating on my bond? If a credit is downgraded from AA+ to AA, the bond might very well still fall within your risk profile, as at the end of the day you still own a AA rated bond. If it was downgraded from AA- to BBB-, it might no longer be appropriate. Consider not necessarily where the bond rating came from, but where it landed.
  • What is the outlook and watch status following the downgrade? If a bond was downgraded and given a stable outlook and not put on a negative watch for another downgrade, the rating agency is telling you that they are not currently reviewing the credit for another potential downgrade and view it as stable. If a bond gets downgraded and remains on negative watch, there is a higher likelihood that another downgrade could be coming.
  • Why was the credit downgraded? Did their leverage ratios increase due to an acquisition that required them to issue more debt? This could be viewed as less concerning if the company is growing and diversifying through the acquisition. If leverage ratios increased due to decreased sales, that tells a very different story. Or maybe revenue projections for a toll-road got reduced. If this is due to decreased drivers as a result of a “shelter-in-place” order, they might be expected to return to normal in a few months; whereas, if it is due to competition from a new high-speed rail line being built, it might be a longer-term problem.
  • Was the downgrade due to some specific event related to that company/municipality (i.e. litigation fallout or a large product failure)? Was it an internal factor or an external factor? Was it something that they can control in the future or something outside of their control. Is it likely to happen again or was it a one-time aberration?
  • Is there something affecting the entire industry/sector (i.e. brick and mortar retail battling the shift to online shopping, a drop in commodity prices, or a regulatory change)? If so, how is the specific credit positioned within the industry/sector and can they overcome those challenges?
  • Was the downgrade related to a long-term negative trend or some sort of immediate shock? If a municipality’s finances have been trending downhill for a number of years due to poor governmental management that might be much more concerning for a long-term investor than a growing school district that was downgraded because they issued more debt to finance the construction of new schools, causing leverage ratios to increase.
  • Is the cause of the downgrade likely temporary or permanent? An airline or an airport downgraded due to travel restrictions might not be a concern assuming they are capitalized well enough to weather the storm, as operations hopefully return to normal sometime soon. On the other hand, if they have been living ”paycheck-to-paycheck”, even a temporary shock could have severe negative effects on the credit.

Every downgrade means something different to each specific credit. Just because a bond was downgraded does not necessarily mean that the company or municipality is doomed. Ultimately, whether or not a bond will “work out” or not for a buy-and-hold investor comes down to one question: will this bond eventually default or not? Remember, a downgrade and a default are two very different things. Yes, if a bond you own is downgraded you should take a fresh look at it and determine if it is still suitable for your risk tolerance and long-term investment objectives. Taking a fresh look at the credit is important and will allow for a proper determination, rather than immediately selling because something was downgraded. Maybe selling is appropriate but in many situations, even with the downgrade, the bond is still an appropriate investment to hold.

Due to a number of factors, a downgrade is oftentimes followed by a decline in price. Price movement does not affect the return for a buy-and-hold investor. If you are holding until maturity, a bond could fall 25%, then climb 50%, then fall again, and rise again … essentially zig-zagging in price for the life of the bond, but as long as the bond doesn’t default, the return to the investor is going to be the same as if the price remained constant for the entire period. If you purchased a bond at 102 and the price has fallen to 95, you haven’t lost that money unless you choose to sell that bond at a loss. The drop in price could be due to general interest rate movements or simple supply/demand dynamics (more sellers than buyers), neither of which likely change the suitability of a bond for an investor. There are essentially two ways to lose money on an individual bond: you choose to sell the bond at a loss or the company defaults. One of those things is in your control. Yes, sometimes a bond no longer aligns with your risk tolerance and needs to be sold, but make sure that you are not selling a bond that still fits your risk profile just because it is showing a loss.  

To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.

The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.

Stocks are appropriate for investors who have a more aggressive investment objective, since they fluctuate in value and involve risks including the possible loss of capital. Dividends will fluctuate and are not guaranteed. Prior to making an investment decision, please consult with your financial advisor about your individual situation.

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