Downgrade Announcements Research Articles

Are Credit Ratings Still Relevant?

We document that firms' stock prices react significantly less to credit rating downgrade announcements when credit default swaps (CDS) trade on their debts. The impact of CDS trading is more pronounced for firms with high-information and financing-related frictions. Prior to a rating downgrade, the ability to trade credit risk via CDS generates information flows from the CDS to equity markets, thereby decreasing the informativeness of credit rating downgrades. Ex post, the ability of lenders to hedge in the CDS market mitigates the loss in access to and cost of financing for downgraded firms. While the CDS market is not a perfect substitute for credit ratings, our results suggest that equity investors rely less on credit ratings in the presence of CDS trading.

Why Do CDO Downgrade Announcements Impact the Bank’s Share Price?

The collapse of the collateralized debt obligation (CDO) market brought attention to the soundness of the involved banks. We infer equity price reaction from rating announcements that are either negative rating outlooks or rating downgrades of CDO. To explain the market reactions, we consider rating shopping and rating grade inflation, reputation of rating agencies, sophisticated or trusting investor behavior and informational asymmetry. While these approaches are not mutually exclusive, our results indicate strong support for regime and time dependency of the sophisticated or trusting investor behavior and informational asymmetry. The trusting investor was dominant in times of market growth right before the outbreak of the financial crisis. This perception has changed so that the sophisticated investor is dominant. Even though rating announcements were expected, feedback channels exist that result in losses. When comparing the stock price reaction of bank related rating announcements, we find that the long term financial outlook is a decisive factor for the investor. As such, we take the bank’s issuer rating and perceive that price effects are well anticipated before the actual announcement day. We interpret the differing market reactions with the availability of information and refer this to an informational asymmetry issue.

Do Corporate Bond Rating Revisions Convey Information About Earnings?

We study the information content that corporate bond rating revisions convey regarding future earnings. Consistent with previous findings, we find that rating downgrades are associated with negative abnormal stock returns, while rating upgrades appear to be nonevents. For rating downgrades, earnings decline in the two years prior to and in the year of the rating downgrade announcement but increase in the year following the rating downgrade. While rating upgrades follow a period of rising earnings, they do not signal any increase in future earnings. These results, in conjunction with our multivariate regression results, indicate that rating agencies respond more to permanent changes in cash flows and provide little information, if any, about future cash flows.

Speed of Price Adjustment of Stocks and Bonds to Changes in Credit Rating

There is a substantial amount of literature concerning equity price movements from a credit rating change, but very little that compares both stocks and bonds abnormal or excess returns from a bond upgrade or downgrade. Using a sample of exchange-­traded bonds from the time period 1994-­2008, the author finds that excess daily and cumulative returns are possible for both stocks and bonds, despite market efficiency theory and asymmetric information. My original hypothesis was two fold; that there would be statistically significant excess returns for bonds and not equities and the excess returns would be significantly higher (and for a longer window of time) on downgrade (as opposed to upgrade) announcements. I found that excess daily and cumulative returns were possible on both stocks and bonds due to downgrade announcements, contrary to the first part of my hypothesis. The second part of my hypothesis was correct. The market does tend to overreact on downgrade news and abnormal returns are possible for both stocks and bonds.

Informed trading before analyst downgrades: Evidence from short sellers

This paper studies short-selling prior to the release of analyst downgrades in a sample of 670 downgrades of Nasdaq stocks between 2000 and 2001. We find abnormal levels of short-selling in the three days before downgrades are publicly announced. Further, we show that this pre-announcement abnormal short-selling is significantly related to the subsequent share price reaction to the downgrade, and especially so for downgrades that prompt the most substantial price declines. Our findings are robust to various controls that might also affect short-selling such as pre-announcement momentum, three-day pre-announcement returns, and announcement-day share price. In addition, the results are independent of scheduled earnings announcements, analyst herding, and non-routine events near downgrades. Further evidence suggests that tipping is more consistent with the data than the prediction explanation which posits that short sellers successfully predict downgrades on the basis of public information about firms’ financial health. Finally, we present evidence that downgraded stocks with high abnormal short-selling perform poorly over the subsequent six months by comparison with those with low abnormal short-selling. Overall, our results support the hypothesis that short sellers are informed traders and exploit profitable opportunities provided by downgrade announcements.

Do Announcements of Corporate Bond Rating Revisions Matter?

This paper examines the stock market impact of announcements of corporate bond rating revisions for companies in the United Kingdom (UK) and in Australia. Investigating the market reaction to bond rating changes by Moody’s and Standard & Poor’s, our findings reveal similar results for downgrade announcements but not upgrade announcements. Using daily data from 1997 to 2006 we find a significant announcement affect to downgrades both in the UK and Australia markets. In contrast, evidence of stock price reaction during upgrade announcements is weak. Subperiod analysis supports these results. Finally, an investigation of the market reaction to a rating change for different bond grades reveals similar results for the UK and Australia in the case of downgrade announcements only.

Informed Trading Before Analyst Downgrades: Evidence from Short Sellers

This paper studies short-selling prior to the release of analyst downgrades in a sample of 670 downgrades of NASDAQ stocks between 2000 and 2001. We document abnormal levels of short-selling in the three days before downgrades are publicly announced. Further, we show that this pre-announcement abnormal short-selling is significantly related to the subsequent share price reaction to the downgrade, and especially so for downgrades that prompt the most substantial price declines. Our findings are robust to various controls that might also affect short-selling such as pre-announcement momentum, three-day pre-announcement returns, and the announcement-day share price. In addition, the results are independent of scheduled earnings announcements, analyst herding, and non-routine events near downgrades. Further evidence suggests that tipping is more consistent with the data than the prediction explanation which posits that short sellers successfully predict downgrades on the basis of public information about firms’ financial health. Finally, we present evidence that downgraded stocks with high abnormal short-selling perform poorly over the subsequent six months by comparison with those with low abnormal short-selling. Overall, our results support the hypothesis that short sellers are informed traders and exploit profitable opportunities provided by downgrade announcements.

An empirical examination of the informational content of credit ratings in China

We examine the certification effect of initial rating announcements and the signaling effect of rating downgrade announcements in China using a pooled time-series cross-sectional issuer rating data of 170 companies listed on the Shanghai and Shenzhen Stock Exchanges from 2002 to July 2006. The empirical evidence supports our hypothesis of an asymmetric certification effect. Consistent with the literature, we also find some negative signaling effects in our rating downgrade sub-sample. Overall, although there are some qualitative arguments that credit ratings in China do not have information content, our empirical findings suggest otherwise. When a normally positively biased rating agency gives a low rating, it is valuable news to market participants.

The Information Content of Commercial Paper Rating Downgrades: Further Evidence

In this paper, we study the association between commercial paper rating downgrades and expectations of the level and variability of future earnings. Our examination shows that such rating downgrades are associated with a significant reduction in analyst forecasts of near-term earnings. We document a tendency by financial analysts at the Value Line Investment Survey to progressively revise their estimates of quarterly earnings downward on average and implement two methods to control for the resulting bias. The reduction in earnings estimates is robust to these controls. In addition, we observe an increase in systematic risk for a subset of firms for which the downgrade implies exit from the commercial paper market. Analysis of stock price changes around the downgrade announcement dates shows that although the information on lower future earnings reflected in mild rating downgrades merely confirms market beliefs, the information on lower level and/or higher variability of future earnings associated with severe downgrades constitutes new information unavailable to the market prior to the rating change announcement.