Rating Migration
See how credit ratings drift over time and what it does to value: project ratings over several years from a one-year transition matrix, reprice the bond at each end rating, and find the expected return after upgrades, downgrades and defaults.
Learning focus: fallen angels, and why a BBB portfolio's biggest risk is a downgrade, not a default.
Illustrative spreads, held constant: a bond that moves to another rating is repriced at that rating's spread.
Rating changes move the return more than defaults do: downgrades cost 33 bp a year net of upgrades, against 10 bp lost to defaults.
| Rating | Probability | Spread | Price | Return | Effect on expected |
|---|---|---|---|---|---|
| AAA | 0.02% | 35 bp | 106.22 | 11.42% | 0 bp |
| AA | 0.10% | 50 bp | 105.09 | 10.29% | 1 bp |
| A | 3.70% | 80 bp | 102.87 | 8.07% | 11 bp |
| BBB | 91.20% | 120 bp | 100.00 | 5.20% | 0 bp |
| BB | 4.00% | 220 bp | 93.26 | −1.54% | −27 bp |
| B | 0.60% | 350 bp | 85.33 | −9.47% | −9 bp |
| CCC | 0.23% | 850 bp | 61.83 | −32.97% | −9 bp |
| D | 0.15% | — | 40.00 | −60.00% | −10 bp |
Per 100 face. Return is over the whole horizon: coupons received plus the price at the end. A defaulted bond recovers 40% of face and keeps the coupons paid before default. The last column is probability × (return − promised); it adds up to the gap between expected and promised.
| From \ to | AAA | AA | A | BBB | BB | B | CCC | D |
|---|---|---|---|---|---|---|---|---|
| AAA | ||||||||
| AA | ||||||||
| A | ||||||||
| BBB | ||||||||
| BB | ||||||||
| B | ||||||||
| CCC | ||||||||
| D | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 100 |
Percent, each row adding up to 100. The sample is illustrative, rounded from the shape of the agencies' long-run average studies; type in the matrix from a specific S&P or Moody's study to use it instead. Default is absorbing.