Why downgrades don't mean doom for investments

(MoneyWatch) When a major corporation or bank is downgraded by one of the major credit rating agencies, it is typically big news. Yet for financial markets, news of downgrades or upgrades doesn't come as a surprise. In fact, the value of stocks and bonds of affected institutions can actually increase after news of a downgrade.

While it may seem counterintuitive, this phenomenon makes sense if you understand how securities are priced. The market takes into account all information known about a firm when pricing its security. This includes what the market expects to see in the future -- both good and bad news. If people are expecting something bad to happen, that information is reflected in the price of the security. If that bad news actually happens, but isn't as bad as expected, the price of the security will likely rise.

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Research from investment firm Dimensional Fund Advisors backs this up. DFA looked at the relationship between credit ratings, market pricing, and perceived risk of corporate debt. Specifically, they looked at Moody's (MCO) June 21 downgrade of 15 major U.S. and European banks. They found that:

• Stock prices rose for 10 of the downgraded firms after the announcement.
• The cost of insuring the debt of Morgan Stanley (MS), one of the downgraded firms, dropped to its lowest level in more than seven weeks.
• In this case, the ratings agency wasn't playing catch-up with market pricing by just a few months. Instead, the agency's ratings were as much as two years behind the level of risk already perceived by the market and factored into prices.

This illustrates the importance of not overreacting to major announcements by making significant changes to your portfolio. Odds are good that the expected news has already been factored into prices and that markets are simply waiting to see if it's better or worse than expected.

It also shows the importance of paying attention to what the market says about a particular security, rather than credit agencies. Even if a bond has a good credit rating, you can be sure there's more to the story if the market has it priced like a riskier issuance.

Image courtesy of Flickr user 401(K) 2012