Are Credit Ratings Redundant When Market Prices Reflect Credit Risk?

Abstract

We find that Credit Rating Agencies (CRAs) see through transitory shocks to credit risk that stem from transitory shocks to equity prices, while market-based measures of credit risk do not. For a given stock return, CRAs are significantly less likely to downgrade firms with transitory shocks than those with permanent shocks. However, credit default swap spreads and model-implied default probabilities do not distinguish between such shocks. These results explain why ratings are useful despite the availability of market-based estimates of credit risk: the ability to ignore transitory shocks is valuable because rating changes have real consequences for private contracts and access to capital.