Project Work on Financial Institutions, Markets &

Services

TOPIC: IMPACT OF
CREDIT RATING
DOWNGRADES ON
CORPORATE BOND
YIELDS
Name: Nilu Kumari

Roll No.: 490-E

Course: BCom(Hons.), Semester V

Submitted To: Vijayvrat Arya Sir

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Contents
INTRODUCTION TO CREDIT RATING........................................................................................................................................ 3

What is a Credit Rating?........................................................................................................................................... 3

Who Uses Credit Ratings?........................................................................................................................................ 3

How are Credit Ratings Determined?................................................................................................................. 3

Types of Credit Ratings............................................................................................................................................. 4

Credit Rating Agencies and Their Role.............................................................................................................. 4

UNDERSTANDING CREDIT RATING DOWNGRADES.............................................................................................................. 5

IMPACT ON CORPORATE BOND YIELDS OF CREDIT RATING DOWNGRADES................................................................6

How Credit Rating Downgrades Affect Corporate Bond Yields............................................................6

Impact of Credit Rating Downgrades on Corporate Bond Prices.........................................................6

Examples of Credit Rating Downgrades and Their Impact on Bond Yields....................................6

REAL-WORLD CASE STUDIES..................................................................................................................................................... 7

Case Study 1: General Motors (GM)........................................................................................................................ 7

Credit Rating Downgrade:....................................................................................................................................... 7

Factors Contributing to Downgrade:.................................................................................................................. 7

Impact on Corporate Bond Yields:....................................................................................................................... 7

Financial Consequences:........................................................................................................................................... 8

Case Study 2: Ford Motor Company (Ford)......................................................................................................... 8

Credit Rating Downgrade:....................................................................................................................................... 8

Factors Contributing to Downgrade:.................................................................................................................. 8

Impact on Corporate Bond Yields:....................................................................................................................... 8

Financial Consequences:........................................................................................................................................... 8

CONCLUSION................................................................................................................................................................................ 9

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INTRODUCTION TO CREDIT RATING
What is a Credit Rating?
A credit rating is an assessment of the creditworthiness of an individual, corporation, or government. It
is a measure of the creditworthiness of an entity, indicating its ability to repay its debts. Credit ratings
are used by lenders and investors to assess the risk of lending money to a particular entity.

Who Uses Credit Ratings?

Credit ratings are used by a variety of entities, including:

• Banks and other lenders: Lenders use credit ratings to assess

the risk of lending money to borrowers. A higher credit rating
indicates a lower risk of default, and therefore, lenders are willing
to offer lower interest rates to borrowers with higher credit ratings.

• Investors: Investors use credit ratings to assess the risk of

investing in a particular company or government. A higher credit rating indicates a lower risk of
default, and therefore, investors are willing to pay a higher price for bonds or other securities issued by
companies or governments with higher credit ratings.

• Insurance companies: Insurance companies use credit ratings to assess the risk of insuring a
particular company or individual. A lower credit rating indicates a higher risk of default, and therefore,
insurance companies may charge higher premiums or refuse to insure companies or individuals with
lower credit ratings.

How are Credit Ratings Determined?

Credit ratings are determined by credit rating agencies, which are private companies that specialize in
assessing creditworthiness. Credit rating agencies use a variety of factors to determine credit ratings,
including:

• Financial statements: Credit rating agencies review the financial statements of companies and
governments to assess their financial health. This includes factors such as profitability, debt levels, and
cash flow.

• Debt history: Credit rating agencies review the debt history of companies and governments to assess
their ability to repay their debts. This includes factors such as the number of times they have defaulted
on debts in the past.

• Economic conditions: Credit rating agencies consider the economic conditions in which a company
or government operates. A company or government that operates in a weak economy may be more
likely to default on its debts, and therefore may have a lower credit rating.

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 Types of Credit Ratings
There are a number of different credit rating scales, but the most common ones are those used by
Moody's Investors Service, Standard & Poor's, and Fitch Ratings. The following table shows the credit
ratings used by Moody's Investors Service:

Credit Rating Description

AAA Excellent creditworthiness

AA Very strong creditworthiness

A Strong creditworthiness

Baa Moderate creditworthiness

Ba Weak creditworthiness

B Highly speculative

Caa Very highly speculative

C Extremely speculative

D Default, with partial recovery

E Default, with no recovery

Credit Rating Agencies and Their Role

Credit ratings are assigned by credit rating agencies, independent organizations that specialize in
evaluating the creditworthiness of entities. The three major credit rating agencies in the United
States are:

1. Standard & Poor's (S&P)

2. Moody's Investors Service

3. Fitch Ratings

These agencies employ a rigorous methodology to analyze an

entity's financial data, including income statements, balance sheets, cash flow statements, and

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debt levels. They also consider qualitative factors such as management quality, industry trends,
and economic conditions.

UNDERSTANDING CREDIT RATING DOWNGRADES

A credit rating downgrade is when a credit rating agency lowers the credit rating of an issuer.
This means that the issuer is now considered to be a riskier borrower, and lenders may charge them
higher interest rates on loans.

There are a number of reasons why a credit rating agency might downgrade an issuer. Some common
reasons include:

 Deteriorating financial performance: If an issuer's

financial performance is declining, this may be a sign
that they are becoming riskier. For example, if an
issuer is losing money or has a high debt load, this
could lead to a downgrade.

 Increased financial leverage: If an issuer is taking

on more debt, this can also make them riskier. This is
because they will have less flexibility to weather
financial shocks.

 Weaker management: If an issuer has weak management, this can also lead to a downgrade.
This is because poor management can lead to poor financial performance and increased risk.

 Industry downturn: If an issuer's industry is facing a downturn, this can also make them
riskier. This is because they may be more likely to experience financial difficulties.

Credit rating downgrades can have a number of negative consequences for issuers. For example, they
may make it more difficult for issuers to raise capital, and they may also lead to higher interest rates
on loans. In some cases, downgrades can even lead to bankruptcy.

How to avoid credit rating downgrades

Issuers can take a number of steps to avoid credit rating downgrades. These include:

o Maintaining strong financial performance: Issuers should focus on maintaining strong

financial performance by generating positive cash flow and reducing debt.

o Managing financial leverage: Issuers should avoid taking on too much debt. This will make
them less risky and less likely to be downgraded.

o Improving management: Issuers should focus on improving their management team. This
will help them to make better financial decisions and reduce risk.

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 o Monitoring industry trends: Issuers should monitor industry trends and make sure that they
are prepared for any potential downturns. This will help them to avoid being downgraded as a
result of an industry downturn.

By taking these steps, issuers can reduce the risk of being downgraded by credit rating agencies

IMPACT ON CORPORATE BOND YIELDS OF

CREDIT RATING DOWNGRADES
How Credit Rating Downgrades Affect Corporate Bond Yields

When a company's credit rating is downgraded, investors become more risk-

averse and demand a higher yield on the company's bonds. This is because
investors are now more likely to lose money if the company defaults on its debt. The
higher yield is a way for investors to compensate for the increased risk.

The size of the increase in yield depends on a number of factors, including the severity of the
downgrade, the company's financial, and the overall market conditions. In general, the more severe the
downgrade, the greater the increase in yield.

Impact of Credit Rating Downgrades on Corporate Bond Prices

In addition to increasing bond yields, credit rating downgrades can also lead to a decrease in bond
prices. This is because investors are now willing to pay less for the bonds, given the increased risk of
default. The decrease in price is proportional to the increase in yield.

Examples of Credit Rating Downgrades and Their Impact on Bond

Yields

In 2018, General Electric (GE) was downgraded from A+ to BBB+ by

Standard & Poor's. The downgrade led to an increase in GE's bond yields of about 1%.

In 2017, Ford Motor Company was downgraded from BBB+ to BBB by Moody's Investors
Service. The downgrade led to an increase in Ford's bond yields of about 0.5%.

In 2015, Valeant Pharmaceuticals was downgraded from BBB- to B+ by Fitch Ratings. The
downgrade led to an increase in Valeant's bond yields of about 5%.

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Credit rating downgrades can have a significant impact on a company's financial including its
ability to borrow money and the cost of its debt. Investors should carefully consider the potential
impact of credit rating downgrades when making investment decisions.

REAL-WORLD CASE STUDIES

To further illustrate the practical consequences of credit rating downgrades and their
impact on corporate bond yields, let's examine three real-world examples:

Case Study 1: General Motors (GM)

Credit Rating Downgrade:
In June 2008, General Motors (GM) was downgraded by
Standard & Poor's (S&P) from BB+ to BB- and by Moody's Investors Service from Ba1 to Ba2. This
downgrade came amidst the financial crisis and its severe impact on the automotive industry.

Factors Contributing to Downgrade:

 The financial crisis led to a significant decline in auto sales, negatively impacting GM's revenue
and profitability.

 The company's debt levels increased substantially, further straining its financial position.

 The overall economic downturn exacerbated these challenges, raising concerns about GM's
ability to meet its financial obligations.

Impact on Corporate Bond Yields:

Following the credit rating downgrade, GM's corporate bond yields
spiked, reflecting the increased risk perceived by investors. The yield
on GM's 10-year bonds rose from 9% to 12%, significantly raising
the company's borrowing costs.

This chart shows the inverse relationship between General Motors

(GM)'s credit ratings and bond yields. As GM's credit rating
deteriorated, its bond yields increased. This is because investors
perceived GM as a riskier investment and demanded higher
yields to compensate for that risk.

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Financial Consequences:
The increased borrowing costs posed a significant challenge to GM's financial recovery efforts. The
company was required to pay higher interest rates on its debt, which reduced its profits and made it
more difficult to invest in new products and technologies.

Case Study 2: Ford Motor Company (Ford)

Credit Rating Downgrade:
In January 2009, Ford Motor Company (Ford) was downgraded by S&P from
BBB- to BB+ and by Moody's from Baa3 to Ba2. This downgrade came as the financial crisis
continued to wreak havoc on the automotive industry.

Factors Contributing to Downgrade:

 Similar to GM, Ford experienced a sharp decline in auto sales due to the financial crisis.

 The company's debt levels also increased, placing additional pressure on its finances.

 The overall economic downturn amplified these challenges, raising concerns about Ford's
ability to repay its debts.

Impact on Corporate Bond Yields:

Ford's corporate bond yields also rose sharply following the
credit rating downgrade. The yield on Ford's 10-year bonds
increased from 8% to 11%, significantly raising the
company's borrowing costs.

This chart shows the inverse relationship between Ford Motor

Company (Ford)'s credit ratings and bond yields. As Ford's
credit rating deteriorated, its bond yields increased. This is
similar to GM, as investors demanded higher yields to
compensate for the increased risk of Ford defaulting on its debt.

Financial Consequences:
The increased borrowing costs posed a significant financial burden to Ford. The company was required
to pay higher interest rates on its debt, which reduced its profits and made it more difficult to
invest in new products and technologies.

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Case Study 3: Lehman Brothers Holdings Inc
Credit Rating Downgrade:

In September 2008, Lehman Brothers Holdings Inc. was downgraded by S&P from A+ to A and by
Moody's from Aa3 to A2. This downgrade came amidst the financial crisis and the company's
exposure to subprime mortgage-backed securities.

Factors Contributing to Downgrade:

 Lehman Brothers was heavily invested in subprime mortgage-backed securities, which

experienced significant losses during the financial crisis.

 The company's exposure to these toxic assets raised concerns about its financial stability and
ability to meet its obligations.

 The overall economic downturn further exacerbated these challenges, leading to fears of a
potential default.

Impact on Corporate Bond Yields:

Lehman Brothers' corporate bond yields skyrocketed following the credit rating downgrade. The yield
on the company's 10-year bonds soared from 7% to 18%, reflecting the extreme risk perceived
by investors.

Financial Consequences:

The increased borrowing costs were unsustainable for Lehman Brothers. The company was unable to
meet its debt obligations and filed for bankruptcy in September 2008, marking one of the largest
bankruptcies in U.S. history.

CONCLUSION
These examples highlight the significant impact that credit rating downgrades can have
on corporate bond yields and the financial health of companies. When a company's credit
rating is downgraded, it signals to investors that the company is riskier and more likely to
default on its debt obligations. This increased risk leads to higher bond yields, which can
make it more difficult for companies to borrow money and can ultimately lead to financial
distress or even bankruptcy.

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THANK YOU

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