Creditwatches and their impact on financial markets

Abstract

Credit rating agencies (CRAs) monitor a firm's creditworthiness and place firms on creditwatch when they observe potential changes in firm characteristics. However, prior research largely focuses on a creditwatch as a single event and neglects the fact that a rating continues to be "on watch" until a final decision is made. This paper examines the impact of creditwatch placements on a firm's credit default swap (CDS) spread and its stock price during the time interval between the creditwatch placement and the final rating decision. The investigation includes 311 rating creditwatch placements (204 negative and 107 positive) from July 2006 to June 2014. The results indicate that stock returns are not different from zero for negative and positive creditwatch placements, whereas CDS spreads continuously increase between a negative creditwatch placement and the final decision. This is a novel result, and therefore creditwatch placements may potentially explain why prior studies found that CDS markets anticipate rating changes. However, this increase depends on the reason for the creditwatch announced by the CRA. The market reaction is strongest for firm-specific performance announcements that may affect the future cashflowdevelopment of a company.