How does IS-LM model reduced investor confidence?
I studied maths not economics so I won't comment on your graphs or theoretic models. In my experience as a rates trader, some economic models have their place but their inherent assumptions do not capture the practical market dynamics. I'll comment on the parts of your question I disagree with. Hopefully you appreciate a devil's advocate.

Firstly, a "a sovereign debt ratings downgrade" by a ratings agency has little value in the world today as a binary event. Most financial practitioners have made up their mind about the credit quality of issuers through independent or public research before ratings agencies update their databases. Ironically, one possibility is that this may indeed be a classic "sell the rumour, buy the fact" scenario, whereby reasonably large speculators sell the bonds preemptively, profit from general declining markets before the ratings downgrade and then use the liquidity and market wide focus generated by the event to exit their positions, and in fact the bonds may actually increase in value slightly due to this. This is classic Jessie Livermore style of trading (Reminiscences of a Stock Operator). There will doubtless be managed funds whose rules preclude investing in junk status bonds so demand for the bonds overall will likely decline overall although I expect more over a period than specifically because of that binary event.

The notion of "bonds" is a very broad term. If an issuer is downgraded the impact may be greater for various different maturities. The UK in the wake of the financial crisis was under considerable pressure due to its reliance on the financial sector and its government bonds underwent considerable re pricing, but the riskier, longer dated bonds suffered considerably worse that the much less riskier, shorted dated bonds, so in that scenario money market bill rates fell but longer bond rates rose.

When I think about the currency wide issue of money, if you have a reasonably large amount of sovereign debt held by investors that is sold those investors then have only a set of options available to them with respect to that money:


reinvest in some other asset denominated in the same currency, corporate bonds or equities.
sell the currency and buy assets in another currency.
deposit the cash with banks or on repo for some form of collateral.


The first of these is just an asset reallocation and weakens sovereign bond prices relative to other assets in the economy. Your argument about government financing is true and the GDP output would be expected to decline, further as confidence also becomes a factor.
The second would weaken the spot FX rate and the cross-currency basis swap levels. Indirectly this threatens to increase inflation since import prices will be affected by the currency movement. However, a weaker currency might tempt outside speculators at some equilibrium point. The third is difficult; no asset manager will deposit funds unprotected with a bank (particularly a domestic one) and the alternative of receiving back sovereign bond collateral is unappealing, so the repo rates will probably be increased in line with the rates on the bonds themselves, although this is another form of interest rate that does have significant impact and is not necessarily the same the bond rates. Indeed there will also be curvature to this as well.

As an example in 2017 the German government bond curve had 0-1Y yields at -70bps, and a repo rate often at similar levels. But the 20y-30y bond yields were at +100bps whilst the repo rate might be at -100bps. This may sound like arbitrage is possible, but it actually isn't - there is no scenario you can gain without running risk, and those different risks were considered and deemed to be worth the values potentially attainable by those who dared.

Finally I will point out to you the transmission mechanism. A central bank presides over its own currency and attempts to influence its economy by changing its deposit rate. However, a central bank is inherently connected to the government. I do not consider it wise to treat the two as separate entities. As a national bank, whose fortunes are intimately tied to the government, you would probably be better off buying and holding the sovereign debt if the short dated bonds offered considerably more interest than the central bank deposit rate, since from their point of view a government failure or a central bank failure might be one and the same. If you consider the holdings of Italian sovereign debt by Italian banks you will recognise this strategy as a kind of moral hazard. So the transmission mechanism is likely to remain in place for the short dated bonds and be ultimately tied to the deposit rate.

I appreciate there is no general conclusion to this thread, and some ideas are not necessarily coherent or consistent. I just found it an interesting question and thought I would explore my own thoughts in raw form. Possibly you find them useful.