What are the risks associated with the disposingof a bond issue in an investment-grade corporatebond index after it is downgraded to noninvestmentgrade?

Question

What will be an ideal response?

Answer 1

The question that is faced by a manager when there is a downgrade is whether or not to sell the downgraded issue.Either action has its own risk. For example, in the decision to dispose of a downgraded issue the portfolio manager may be giving up characteristics of the bond that has a positive influences (such as adding to the overall average maturity of the portfolio). For some institutions (such as insurance companies) keeping the downgraded bondhas a risk associated with removing an issue that will cause it to realize a loss it may not be able to afford. The Ng and Phelps study provides preliminary evidence for holding issues that have been removed from the Barclays Capital Investment Grade Corporate Index. This evidence suggests a number of implicit risks associated with the disposing of a bond issue in an investment-grade corporate bond index after it is downgraded to noninvestment grade. The risks are associated with losing desirable portfolio features such as liquidity, maturity, duration and so forth.

For portfolio managers granted the flexibility of retaining a fallen angel, the question is whether there will be better long-term performance by disposing of the bond shortly after the announcement of the downgrade or retaining it in the portfolio. The disadvantage of disposing of the fallen angel is that given the limited liquidity in the corporate high-yield market, a liquidation that occurs at the same time as other portfolio managers who are either forced to liquidate or elect to do so can result in a sale price of a fallen angel that is below its fundamental value. Thus, we have the risk of selling an underrated bond. There is empirical evidence to support this. For example, Dor and Xu investigate whether there is price pressure after an investment-grade issue is downgraded to noninvestment grade as portfolio managers collectively divest themselves of the downgraded issue. The findings provide strong support for such price pressure, resulting shortly after downgrading in a market price below fundamental value.