How does 'Rating Migration Risk' affect the Net Asset Value (NAV) of a debt mutual fund scheme holding corporate bonds?

[ A ]When a bond's credit rating is downgraded (e.g., from AAA to AA+), the market demands a higher credit spread, causing the bond's price to drop and lowering the scheme's NAV.[ CORRECT ]

[ B ]When a bond is downgraded, its coupon interest payment automatically triples, boosting scheme NAV instantly.

[ C ]Rating migration has zero effect on bond prices because credit rating agencies do not publish public reports.

[ D ]Rating migration only affects equity shares and has no applicability to debt and money market instruments.

Takeaway

Option A is correct: When a bond's credit rating is downgraded (e.g., from AAA to AA+), the market demands a higher credit spread, causing the bond's price to drop and lowering the scheme's NAV.

Derivation

Rating migration risk refers to the potential price volatility in fixed income securities resulting from changes in their assigned credit ratings. When a credit rating agency downgrades an issuer (e.g., from AAA to AA+), the market perceives higher credit risk and demands a wider credit spread (higher yield). Because bond prices move inversely to yields, the secondary market price of the downgraded bond falls immediately, resulting in a mark-to-market decline in the scheme's NAV. This tests credit risk mechanics. A common mistake is believing credit risk only matters on complete default.

Why the others fail

B — When a bond is downgraded, its coupon interest payment automatically triples, boosting scheme NAV instantly.

Downgrades do not increase fixed contractual coupons; they depress secondary market bond prices, reducing scheme NAV.

C — Rating migration has zero effect on bond prices because credit rating agencies do not publish public reports.

Credit rating downgrades are public market signals that immediately trigger secondary market repricing and valuation markdowns.

D — Rating migration only affects equity shares and has no applicability to debt and money market instruments.

Rating migration is a central risk in debt securities; credit rating agencies evaluate debt default risk, not equity stock prices.