In the curriculum, I saw that when we try to calculate the return of a bond due to a credit migration, we incorporate the changes in the return from every possible category like A bond becoming BB, A becoming CCC and so forth, and then we calculate the return. Does this mean we are trying to find the expected return on the bond based on all the scenarios ?
Also when we calculate the credit spread of a bond going from A to BB which number do we put to calculate the difference?
Lastly why do we say that the credit migration has a negative impact on a bond’s return? if the bonds rate goes down, doesnt it mean that the return should be higher given the high risk of default?
Do this only if they ask you to calculate the expected return of the bond (with no specific direction of the credit migration, that means average out all scenarios based on the probability of migration and the %change in price).
If you are assuming the scenario that the rating will drop from A to BB (one scenario only), then if:
Credit spread of A-rated bonds = 1.20%
Credit spread of BB-rated bonds = 3.50%
Modified duration of A-rated bond = 8.00
Return = -Spread Duration \times (BB Spread - A Spread)
Return = -8 \times (3.50% - 1.20%) = -8 \times 2.30% = -18.4%
When the rating is downgraded, the credit spread increases, which then increases the YTM \to bond price declines (instantaneous paper loss at the point of rating downgrade). If the bond is currently a discount bond and you hold it to maturity (without any default happening), then you can make a good return from the bond.
thank you for taking the time to reply.
Ill go over your explanation and see if its actually making sense
I think I still dont get how credit migration has a negative impact on the return of a bond.
Like if we have an A rated bond giving us 10% and now suddenly, it becomes BB rated bond, should our return go high?
A credit rating downgrade (e.g. from A to BB) means the bond’s credit risk is perceived to be higher. This will usually trigger fund managers to sell off the bond (for some, their investment mandates do not allow holding bonds of a weak rating). This sell-off will result in a drop in the bond price (resulting in losses for those who hold it) --> which results in higher YTM.
But of course, if you do not think a default is likely to happen, you will buy the bond at a lower price and hold it either till it matures or if the rating is upgraded (and people start buying), then you can a handsome return from it (but that requires holding it for some time).
1 Like