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NISM Certifications · NISM-Series-XXI-A: Portfolio Management Services (PMS) Distributors · Investing in Fixed Income Securities (NISM XXI-A)

A credit rating agency downgrades a corporate bond issuer from AA to A. What is the most likely immediate effect on the market price of the issuer's existing bonds?

The price of the existing bonds will most likely fall. A downgrade signals higher credit risk, so investors demand a higher yield. Since coupons are fixed, the only way to deliver that higher yield is through a lower market price.

  1. APrice rises because yield falls
  2. BPrice falls because investors demand a higher yield for higher credit riskCorrect
  3. CPrice remains unchanged because the coupon is fixed
  4. DPrice rises because the maturity shortens

Explanation

A downgrade signals higher default risk, so investors require a higher credit spread. A higher required yield reduces the present value of the fixed cash flows, so the price falls.

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