Credit Migration Risk and Expected Return

Hi there,

I am trying to understand the concept of credit migration risk and how it impacts the expected return.

Credit migration risk is the risk that the credit rating of a bond changes. If the credit rating goes down, typically we would demand for higher return whereas if the credit rating improves, we would demand less return. However, as per the curriculum, the credit migration risk reduces the expected return which I am not sure to have understood why.

Can someone pls help me?

Hi,

If you invest in a _ fixed-rate AAA bond _ holding the note until maturity your return is initially fixed (c.p.). However, if the credit risk increases ex-post (i.e. increased risk of default) bondholder’s expected return will decrease. This mechanism holds true also for a floating-rate bond.

In your argumentation is only true from an _ ex-ante perspective _ where a decreased market price of the bond will compensate for the additional risk.

Regards,

Oscar

Hi Oscar,

Sorry let me see if I got it. Lets assume you have a bond AAA which is supposed to pay you , lets say 10%. Now lets assume that its rating went to AA which pays you 13%. So because you are holding the AAA bond you wont benefit the 13% return hence, you return is negatively impacted? Is my understanding correct?

Do i make sense?