The information content of rating action reports: A topic modeling approach

Abstract

This paper examines the information content in Moody's rating action reports, which Moody's releases concurrently with its rating actions. Using a topic modeling approach, we identify two informative topics after controlling for rating characteristics and report tones. We find that unfavorable discussion of the Metrics topic (about issuers' financial performance) generates a significant positive market reaction, while unfavorable discussion of the Liquidity topic (about issuers' liquidity profile) generates a significant negative market reaction around rating actions. Together, these two topics increase the explanatory power of market reaction around rating actions by over 10%. Further analysis reveals significant associations between these two topics and future default likelihood and debt-paying ability, and the associations are consistent with market reaction to these topics. Although investors have less confidence in rating reports following the Dodd-Frank Act, these two topics are more predictive of future default probabilities. Overall, we find that rating reports topics provide important information to investors as they significantly predict future default likelihood and financial performance.