As I understand it, Degeneration is only meant to occur when the parents of the child are related. However, the parents of this child are not related (though one is Degen Grade 3), and yet the baby is Degen Grade 2:

http://beastkeeper.com/pet/35852

Is this a bug, or have the degeneration mechanics been changed?

Thanks for reporting.

I'm extremely sorry, there was a major misunderstanding between me and coder on the Degeneration mechanics. It reduces only by 1 grade for each breeding to not related pet. The degeneration for all the pets is recalculated according to the rule which I posted to remove the harm done by this misundertanding. Degeneration will start working as it was intended initially with tomorrow update. I'll update the FAQ in a while too.

Sorry once more.