The value of credit rating changes across economic cycles

Abstract

This paper examines how credit rating changes of US based firms affect equity markets in differing economic conditions and across different bond types. This study examines cross-sectional reactions upon a rating change, controlling for potential variance changes on the event day. Consistent with earlier works, we document a negative wealth effect for downgrades and no reaction for upgrades. Interestingly, however, we find there is a significant difference in stock price reaction to downgrades during periods of contraction versus periods of expansion. Reactions to downgrades are driven by smaller firms. Speculative firms are also more likely to hold higher risk of default and these firms see significant stock price reactions following a credit rating change due to both higher information asymmetry and default likelihood.