The Effect of Bond Rating Changes on Common Stock Prices

Information is the lifeblood of equity trading, and a rating change for a company's bonds can be an important factor in determining whether investors want to buy or sell that company's stock. A change in that rating may move stock prices. That's why it's important to understand what bonds and bond ratings are, how they work and how they can impact share prices.

Definition and Purpose of Bonds

Sometimes companies need more money than banks can lend them, so they reach out to the public via the bond market to ask for what are essentially IOUs or loans. Corporate bonds can last for a short period, such as two years, or longer than eight years. Generally, corporate bonds are issued in $1,000 or $5,000 amounts and pay interest. As with many elements of finance, there are exceptions. Corporations generally use bonds to fund large projects such as the acquisition of another company or the construction of new factories. If you're a public company, issuing bonds can be preferable to issuing new stock to fund these types of business investments, because issuing new stock dilutes value for existing shareholders.

Bond Ratings Are a Corporate Credit Score

Just as we all get a credit score from a ratings agency, so too do public companies. The same factors that are used to compile your credit score are also used to determine a bond rating. When assigning a rating for a corporation's debt, the agencies look at the company's history of repayment, its income and assets and its other liabilities. If the company scores well on these elements, its bonds will get an "investment grade" rating. If the company performs poorly, its bonds will be given "junk" status. The most commonly known ratings agency is Standard & Poor's (S&P), which uses a letter-based ratings system. The "AAA" rating from S&P means the company is in a sound position to pay its debt. A rating of "D" indicates the company has defaulted on its bonds. Moody's and Fitch are other well-known ratings agencies that use comparable ratings systems.

Significance of Ratings Changes

If a company's bond rating is stable or improving, there's little evidence that this will impact share prices. Under these conditions investors are mindful of the bond rating, but it's only one factor they consider. The company's fundamentals and technical indicators may be more important to market psychology. It's a ratings downgrade that is most likely to move stock price, and it will almost certainly lower the share value. What a ratings downgrade tells investors is that there is something in a public company's reported data that gives the ratings agency pause. It suggests there's something to be concerned about.

Controversy

Since the financial crisis of 2008, the usefulness of the models employed by the three major credit ratings agencies has been questioned. Nevertheless, investors need to know that a company's share price is likely to be punished on the news that the company's bond rating is being reviewed or downgraded.