Default risk vs downgrade risk — how should I think about them separately?

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AcadiFi · Accepted Answer

Default risk is the probability the issuer fails to make contractual payments and creditors recover only a fraction. Downgrade risk (a subset of migration risk) is the probability the issuer's rating deteriorates without defaulting, widening its spread and reducing bond price. Think of a transition matrix: a BBB bond over one year might stay BBB with 86% probability, upgrade to A with 4%, migrate to BB with 6%, migrate to B with 2%, migrate to CCC with 1.5%, and default with 0.5%. Each non-default migration produces a mark-to-market P&L based on the new rating's spread level. For Stratos Ridgefield Holdings trading at a 220bp spread, a downgrade from BBB to BB might push its spread to 420bp, causing an 8% price loss even though no default occurred. Default produces a much larger loss (typically 55-65% of face) but happens rarely. Capital frameworks recognize this: CreditMetrics computes credit VaR by simulating all migration states including default, while simpler default-only models (CreditRisk+) ignore downgrade mark-to-market. For trading books, downgrade risk dominates short-horizon P&L variance because migrations happen far more often than defaults. For hold-to-maturity books, default risk dominates realized losses. Understanding both is essential for IFRS 9 expected credit loss staging.

Default risk vs downgrade risk — how should I think about them separately?

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