Credit Rating Downgrades Research Articles

What moves stock prices around credit rating changes?

Using monthly and multi-day return windows, research shows that credit rating downgrades often reveal new information and lead to significant stock price reactions but that upgrades do not. Using intraday data, we revisit these findings and extend them by examining the possibility of informed trading ahead of the announcement of credit rating changes. Credit rating agencies delay public announcements of rating changes to provide issuers with time to review and respond to rating reports, which opens the door for informed trading in advance of credit rating changes. Using data on rating changes from S&P, Moody’s, and Fitch, we find a more modest price reaction to rating downgrades than documented elsewhere and show that stock prices respond to changes in long-term issuer ratings but not to changes in ratings of a single instrument or a subset of instruments. Most interestingly, we find that prices start moving before a downgrade announcement, controlling for other news and investor anticipation. These pre-announcement movements are concentrated among observations where credit analysts are motivated to disclose private information to advance their careers. The beneficiaries of these disclosures appear to be institutional investors.

A behavioral explanation of credit ratings and leverage adjustments

We study the effect of firms’ credit rating changes on their leverage adjustments. We consider behavioral (the prospect theory) and firm-related factors to converge the divergent views on firms’ capital structure. Our position is novel and not in the vein of the prior literature. The adjustment speed is insensitive to the credit rating changes for the under-levered firms. For the over-levered firms, being near a credit rating downgrade has a positive effect on the adjustment speed. However, being near a credit rating upgrade does have any impact. Also, a credit downgrade (upgrade) has a positive (negative) impact on the adjustment speeds of the over-levered firms. The over-levered firms that experience a credit downgrade struggle to regain their previous ratings by reducing leverage at a faster rate. In most cases, the firms’ reactions to credit rating changes are in line with the loss aversion aspect of the prospect theory.

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Impact of trade credit on supply chains with downgraded customers

Trade credit is the liquidity provision from suppliers to customers. In this paper, we examine the use of trade credit in the supply chain after customer firm's credit rating being downgraded. We find that trade credit is likely to decrease after customers getting downgraded credit ratings. We further show that suppliers and customers will be both better off in profitability if trade credit increases following customers' credit rating downgrades. Given that the use of trade credit generally has a significant positive effect on suppliers' and customers' profitability, we show that this effect is stronger when customers receive credit rating downgrades. The empirical evidence in our paper suggests that strengthening the financial collaborations in the supply chain is a superior strategy relative to shrinking the financial collaborations under the circumstance that customer firms suffer from a growing financial constraint and financial distress.

The impact of sovereign credit rating changes on government bond yields in South Africa

This study applies an event study analysis on Standard & Poor's (S&P), Fitch and Moody's sovereign credit ratings for South Africa over the period 2007 to 2018 to investigate the impact of long-term foreign currency sovereign credit ratings changes on 30-year sovereign bond yield. Results of the analysis find a generally significant increase in bond yields before, during and after credit rating downgrades and negative outlook events. However, there was no statistically significant impact on bond yields associated with upgrades and positive outlook events. It is thus concluded that investors in South Africa's long-term bonds are more sensitive to negative credit rating events, which are mainly driven by structural problems in the economy. This paper recommends monetary and fiscal authorities to address the concerns raised by rating agencies in review reports leading to negative outlook and downgrades before they become more apparent to trigger negative rating actions.

Do bank stress tests reduce the reliance on credit rating downgrades?

Applying event study methodology on the US stock market, we present evidence that investors rely more on credit ratings for banks relative to non-financials and attribute this to a higher level of opacity. This effect is even reinforced during the financial crisis as bank opacity generally increases during stress periods. In response to the crisis, stress tests were introduced by the Federal Reserve in 2009 to alleviate the negative effects of bank opacity. We show that the stress tests have reduced the reliance on rating downgrades for stress-tested banks, and hence conclude that the tests succeeded to reduce bank opacity. However, we also find that the effect starts to decrease 6 months after the stress test disclosure. Moreover, stress tests do not affect the reliance on credit ratings for non-stress-tested banks, indicating that stress tests do not resolve potential negative effects of bank opacity for non-stress-tested banks. Our results suggest that policy makers should consider increasing the frequency of stress tests and extending the sample of stress-tested banks.

Credit Rating Downgrade Risk on Equity Returns

We develop a four-factor model intended to capture size, value, and credit rating transition patterns in excess returns for a panel of predominantly mid- and large-cap entities. Using credit transition matrices and rating histories from 48 US issuers, we provide evidence to support a statistically significant negative downgrade risk premium in excess returns, suggesting that stocks at higher risk of failure tend to deliver lower returns. The performance of the model remains robust across several estimation methods. Panel Granger causality test results indicate that there indeed is a Granger-causal relationship from credit rating transition probabilities to excess returns. Our paper thus provides a new methodology to generate firm-level downgrade probabilities and the basis for further empirical validation and development of Fama-French-type models under financial distress.

The corporate credit rating changes and firm returns in a transitional economy: The case of South Africa

Background: Investors depend on rating agencies to provide an independent assessment of the ability of companies operating in the transition economy to meet their debt obligations. Any change in a firm’s credit rating conveys informed signals about the financial health of the firm and that information should offer markets better knowledge about the future prospects of the firm’s ability to pay creditors and equity holders. What we do not know is the magnitude of the impact of credit rating change on the stock yields of companies operating in a transitional and risky economy like South Africa. The literature indicates that the amount of influence that a rating agency has on equity returns is ambiguous. Objectives: The purpose of this study is to determine whether companies’ share prices react to a change in credit rating. The study also investigates the financial risk factors that differentiate between credit rating downgrades and upgrades. Methods: The event study methodology was utilised to measure the abnormal returns of companies listed on the Johannesburg Stock Exchange (JSE) that had a credit rating change between 2005 and 2015. Logistic regression was used to establish the financial factors influencing the direction of credit rating change. Results: We found that there was no significant impact evident on equity prices when companies’ credit rating upgrades were announced by the credit rating agencies, indicating that the upgrades are largely anticipated by the market at the time they are announced. However, the market reacts significantly negatively when companies’ credit rating downgrades are announced, suggesting that only credit rating downgrades contain relevant pricing information. The finding implies that the credit rating downgrades may lead to disinvestment from the economy, leading to deterioration in macroeconomic indicators in the country within which the firm operates. Furthermore, factors, including interest cover and firm earnings, are significant in differentiating between credit rating upgrades and downgrades, implying that debt issuers in South Africa can manage their credit rating by managing specific financial risk factors. Conclusion: In an emerging and transitional economy like South Africa, the market reacts significantly negatively to credit rating downgrades, just as they do in developed countries like the USA. Stock prices react negatively to credit rating downgrades because credit rating agencies convey adverse private information about a company through these downgrades.

Supply‐side factors, CEO overconfidence, and zero‐leverage policy

AbstractThis paper investigates the effects of credit rating downgrades, equity mispricing, and CEO overconfidence on zero‐leverage policy, using data for listed U.S. firms during the period 1980–2012. The results show that (a) the likelihood of zero leverage increases significantly following a downgrade in credit rating; (b) zero leverage is the outcome of the past attempts by firms to issue more overvalued equity capital; and (c) firms with overconfident CEOs are more likely to choose zero leverage. The results clearly suggest that the conditions prevailing in both credit and equity markets exert significant influence on zero‐leverage policy. The analysis also advocates the inclusion of managerial biases in conjunction with the market‐wide conditions in the analysis of zero‐leverage policy. Overall, the findings reveal that zero‐leverage firms find that the benefits of issuing overvalued equity outweigh the benefits associated with debt financing. These results are robust to a battery of checks.

IMPACT OF CREDIT RATINGS ON STOCK RETURNS

This study investigates whether a change in credit ratings lead to a change in dailyexcess stock returns. The sample includes daily stock price data for US firms listedon the Standard & Poor’s 500 from January 2006 to December 2015. Firms’ excessstock returns are compared with the market in a 14-day window around credit ratingdowngrades and upgrades. Our results are asymmetric, that is, there is a significantreaction to credit ratings downgrades but not to upgrades. In addition, we report weakevidence of upgrades in credit ratings since the 2008 global credit crisis leading tosignificant changes in security prices.

The Impact of Credit Rating Change on Investor Sentiment

The behavioral finance literature focuses on the effect of investor sentiment on the fundamental values of individual stocks. This study constructs a firm-level investor sentiment indicator based on transaction and price data for individual firms and shows that credit rating changes affect investor sentiment. We find the following empirical results. First, the response of investor sentiment to upgrades (downgrades) is significantly positive (negative). Second, the greater the magnitude of the downgrade is, the more negative the investor sentiment reaction is, although we do not find a similar result for upgrades. Third, cumulative abnormal returns around the event day are affected by cumulative abnormal sentiment before that day. This result suggests that the market reaction is affected by a combination of credit rating downgrades and investor sentiment.

Do Reputable Issuers Provide Better-Quality Securitizations?

We examine the link between issuer reputation and mortgage-backed security (MBS) performance using a sample of 4,247 European MBS issued between 1999 and 2007. We measure performance with credit rating downgrades and delinquencies and track their changes over the long term. We find that, overall, MBS sold by reputable issuers are collateralised by higher quality asset pools which have lower delinquency rates and are less likely to be downgraded. However, as credit standards declined during the boom period of 2005-2007, asset pools securitized by reputable issuers were of worse quality compared to those securitized by less reputable issuers. Therefore, reputation as a self-disciplining mechanism failed to incentivise the production of high quality securities during the credit boom. JEL Classification: G21, G24, G28

The Effect of Credit Rating Downgrades and Customer-supplier Relationships

Extant research documents the valuation effects of credit rating change on the stock price. This study extends the research by examining the information transfer effects of customer credit rating downgrades on supplier firms. We find that supplier firms experience negative abnormal returns during the announcement of customer firms’ rating downgrades. This effect persists over a 50 trading day window after the downgrade announcement. We also find that credit rating deterioration spreads along the supply chain, where the probability of future rating downgrades is significantly higher for supplier firms with downgraded customers. Further, we show that the information transfer effects are associated with certain cross-sectional factors, including the market anticipation of customers rating downgrades, the strength of the customer-supplier linkage, the valuation effects within customer firms’ industries, and investor attention on supplier firms.

Do analysts really anchor? Evidence from credit risk and suppressed negative information

Abstract Recent findings indicate that stock analysts suffer from anchoring bias as they anchor their earnings per share forecasts on the industry median without making sufficient adjustments. Using a sample of firms rated by Standard and Poor's, we determine that this finding is concentrated in the worst rated firms, especially around credit rating downgrades. The driving force of the finding is that stock analysts suppress negative information for high credit risk stocks by dropping coverage instead of issuing low earnings per share forecasts, especially around credit rating downgrades. Our finding explains not only why stock analysts seem to suffer from anchoring bias, but also why analysts are overly optimistic for high credit risk stocks.

Do Credit Default Swaps Mitigate the Impact of Credit Rating Downgrades?*

We find that a firm’s stock price reaction to its credit rating downgrade announcement is muted by 44–52% when credit default swaps (CDSs) trade on its debt. We explore the role of the CDS markets in providing information ex ante and relieving financing frictions ex post for downgraded firms. We find that the impact of CDS trading is more pronounced for firms whose debt financing is more dependent on credit ratings (e.g., those rated around the speculative-grade boundary, those with a higher number of rating-based covenants). Reductions in debt and investment, and the increase in financing costs are less severe for CDS firms than non-CDS firms following an identical credit rating downgrade. Our results suggest that CDSs mute the stock market reaction to a credit rating downgrade by alleviating the financing frictions faced by downgraded firms.

The Moderating Effect of Disclosure Quality on Changes in the Cost of Debt: Evidence from Municipal Credit Rating Downgrades

We examine whether municipal market participants' sensitivity to changes in local home values varies with the quality of local governments' financial reports. We find the credit ratings and bond yields of governments that are required to comply with GAAP are less sensitive to changes in local home values than similarly-affected governments that are not required to comply with GAAP. These governments do not experience different changes in net revenues ex post. The results are pronounced when the change in home values generates the most uncertainty (i.e., the change is adverse). The results are also stronger after GASB 34 increased the quality of GAAP-compliant issuers' financial reports. We conclude that market participants are less sensitive to signals about the local economy when local governments are required to provide high-quality disclosures.

The use of earnings and operations management to avoid credit rating downgrades

Firms placed on negative credit watch face the threat of a credit rating downgrade. At the same time, they are given the opportunity to put recovery efforts in place to retain their current credit rating. In this paper, we test to what extent firms use earnings management as a short-term recovery strategy. We find that both accruals-based and real earnings management are associated with firms avoiding credit rating downgrades, and that these alternative earnings management strategies tend to be complements rather than substitutes. However, following the passage of the Sarbanes–Oxley Act, only real earnings management is significantly associated with the credit watch outcome. We find evidence that firms which maintain their rating via earnings management are better able to afford the inevitable earnings reversals, and that in the year following the credit watch period, the credit rating performance of these firms is significantly better than firms which undergo a downgrade, with fewer downgrades and more upgrades in this period. Our results also imply that credit rating agencies are not misled by earnings management but rather allow for some discretion in reporting earnings that facilitates the dissemination of private information about future firm performance.

Supplier-Customer Relationships and Corporate Hedging Policy

We investigate the relation between a firm’s hedging policy and its major customer relationships. We find that the likelihood of a supplier using derivatives to hedge interest rate risk is higher when a major customer has high leverage. This result is increasing in the supplier’s dependence on a major customer, such as when the customer represents a large share of its sales, when the supplier operates in a durable goods industry, or when the supplier makes high relationship-specific investments. We also find that hedging helps the supplier maintain durable relationships with customers, especially highly leveraged customers. Further, we find that announcements of customers’ bond offers and credit rating downgrades have more negative effects on the market value of non-hedging suppliers than that of hedging suppliers. These results suggest that a major customer’s financial health is an important determinant of a supplier’s hedging policy, and that supplier hedging helps increase the perceived viability of the future customer relationship and alleviate potential negative spillover effects along the supply chain.

Credit Rating Downgrades and Sudden Stops of Capital Flows in the Eurozone

The current paper investigates the impact of sovereign ratings on sudden stops of capital in the context of the Eurozone. Our analysis focuses on the qualitative aspect of ratings on the hypothesis that such aspect has a concrete impact on capital movements. A panel probit model is utilized for our purposes. We distinguish between net and gross capital inflows, while we also draw a distinction between long-term and short-term oriented capital. Our results confirm the influence of sovereign ratings for the majority of our model specifications. They also appear to be most significant in the case of short-term flows.

December Doldrums, Investor Distraction, and Stock Market Reaction to Unscheduled News Events

We examine how investor distraction during the December holiday season impacts the stock market’s reaction to salient firm-specific news and whether this response is different for scheduled versus unscheduled news releases. We find that the price and volume response towards unscheduled news, such as credit rating downgrades and 8-K filings, is significantly weaker in December compared to other months. In contrast, after addressing selection issues, we find no equivalent effect for pre-scheduled earnings news released in December. Consistently, we also find that both retail and institutional investor attention to unscheduled firm-specific news is lower in December, but not so for scheduled news. Moreover, larger firms, firms with higher analyst following, or higher institutional ownership, are less susceptible to this December distraction effect towards unscheduled news. Our results highlight how investor distraction during the December holiday season can lead to a muted market reaction to unscheduled, but salient, firm-specific news.