Final answer:
A bond unexpectedly downgraded from AAA to BAA would see a decrease in price as the yield would have to increase to match the higher market yield expected for riskier BAA bonds.
Step-by-step explanation:
When a bond's credit rating is downgraded, as in the case from AAA to BAA, its yield typically increases to compensate investors for the higher risk of default. In December 2020, AAA bonds yielded 1.29% while BAA bonds yielded 3.11%. Seeing as the bond was downgraded unexpectedly, this implies a higher perceived risk and therefore the market will demand a higher yield.
If the market yield on BAA bonds is 3.11% and the bond in question is yielding 1.29%, the price of the bond will likely fall as its yield has to increase to match the market yield for BAA bonds. Consequently, bondholders may sell the bond at a discount, translating to a lower price in the market.
For a 10% 5-year bond, the fall in price would reflect the new yield required by investors to match the BAA market yield. It's similar to our third reference example, where a change in market interest rates affects the price one would pay for a bond. If the interest rate is lower than the market rate, the price of a bond must decrease to offer a return that is competitive with current market rates.