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I'm not sure how bond yields were decreased by the US credit rating downgrade in 2011. Since the credit rating is down, shouldn't the yields increase since the US government wants to attract more bond buyers?

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  • $\begingroup$ Can you provide any reference to a credible that would suggest the downgrade of credit rating was the cause behind decreasing yields? $\endgroup$ – 1muflon1 Aug 30 '20 at 17:33
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    $\begingroup$ @1muflon1 - at the time the consensus opinion was that the downgrade indicated higher risk in the world economy, leading in the short-term to lower share prices, a movement of capital to the dollar and lower US bond yields $\endgroup$ – Henry Aug 31 '20 at 0:52
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My guess is this is a coincidence. That is, the effect of the credit rating agencies was either approximately zero, or if it was substantial and negative, that this was swamped out by other factors.

If bond ratings have a causal effect on yields, that effect is usually for smaller issues and smaller issuers where the market depends on the rating agencies for critical information. For the big issuers the banks are well informed on the issuer and need the rating agency less.

For example, consider the paper The relationship between credit default swap spreads, bond yields, and credit rating announcements (JBF 2004). When they look at CDS spreads, which are mostly for bigger issuers, they find:

By pooling all observations we find a significant (at the 1% level) increase in the CDS spread well in advance of a downgrade event. In the case of reviews for downgrade and negative outlooks there is a significant (at the 1% level) increase in the CDS spread during the 30 days preceding the event. CDS spreads increase by approximately 38 bps in the 90 days before a downgrade, by 24 bps before a review for downgrade, and by 29 basis points before a negative outlook. When observations are pooled there are no significant changes in CDS spread during the 10 business days after any type of negative event.

I interpret this as saying that bond markets seem to react to the information on these larger issuers that the credit rating agencies are also using to change their ratings and at the same time they are considering those changes. However, the actual rating change, the information in that rating, and the reasoning behind it doesn't matter much. What holds for large corporate issuers is going to be even more true for a large issuer like the US government.

However, there is alternative evidence from the sovereign market in Europe. Credit rating agency downgrades and the Eurozone sovereign debt crises (JFS 2016):

This paper studies the reaction of the Euro's value against major currencies to sovereign rating announcements from Moody's, S&P and Fitch CRAs during the Eurozone debt crisis in 2010–2012 based on event study methodology combined with GARCH models. We also analyze how the yields of French, Italian, German and Spanish government long-term bonds were affected by CRA announcements. Our results reveal that CRA downgrades, watchlist and outlook announcements had no impact on the value of the Euro currency but increased exchange rate volatility. At the same time, downgrades as well as negative outlook announcements increased the yields of French, Italian, and Spanish bonds and even affected the German bond's yields. This shows that the monetary union has led to a breakdown of the consequences of the rating shocks between currency value and sovereign bond yields. The reason is that part of the rating shock is absorbed by an internal repricing of sovereign bonds.

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It is very difficult to explain why financial market prices change. Theoretically, you would need to get honest answers from all market participants as to what their strategies are - and no sensible market participant will offer that information.

  • However, it should be noted that the rating on US Treasury securities is a formality, and would likely only cause technical problems for investment mandates if they fell below investment grade. Treasury securities have special status in risk measures, and that status is not dependent upon what some rating agency says.
  • I was working in finance, and remember that incident. The news hit after close, and was the subject on weekend news specials. When the markets re-opened Monday, equity markets fell. Bond prices at the typically had a negative correlation with equities, and so it was not surprising that bond prices went up/yields went down.

There’s really no way of knowing whether bond yields fell because economic conditions were downgraded (e.g., investors expected spending cuts from Congress), or was a reaction to equities. Meanwhile, it is unclear what was happening in equity markets.

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  • $\begingroup$ Hi @Brian Romanchuk what do you mean by "Bond prices at the typically had a negative correlation with equities"? $\endgroup$ – Sean Taylor Sep 5 '20 at 4:23
  • $\begingroup$ If equities rose that day, bond prices fell, and vice-versa. $\endgroup$ – Brian Romanchuk Sep 5 '20 at 19:21

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