A bond that used to have an investment-grade rating before its credit rating has started to deteriorate down to junk bond status. Credit rating gets downgraded mainly due to weakness of an issuer’s ability to service the debt, whether on an actual or expected basis. A precursor to downgrade is an increase in the credit premium added to the bond’s yield on account of potential weaknesses in the issuer’s condition.
Bond yields can move up after a downgrade if the market for these bonds becomes less liquid. However, in reality abnormal post-downgrade illiquidity may not be observed, using market liquidity indicators such as the CDS basis. Illiquidity may, at times, be explained by abrupt changes in the economic outlook and broader market stress, among others.
