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Review of Accounting Studies

Erschienen in:

07.01.2021

What moves stock prices around credit rating changes?

Erschienen in: Review of Accounting Studies | Ausgabe 4/2021

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Abstract

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.

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An SEC report on the role and function of credit rating agencies (SEC 2003) says: “Some [hearing participants] expressed concern that […] the informal verbal contacts between subscribers and rating agency analysts increased the risk of improper disclosure of confidential information provided by the issuer. Others believe these contacts could inappropriately signal to subscribers information about upcoming ratings changes (and their associated market impact).”

We account for each overnight period (i.e., the period between 16:00 of day t-1 and 9:30 of day t) as one trading minute.

For example, for downgrades, Holthausen and Leftwich (1986) find an average announcement return of −2.66%. Chava et al. (2012) document a mean return of −4.31% using a two-day announcement window. Jorion et al. (2005) find an average announcement return of −4.57% (−6.93%) for pre- (post-) Reg FD periods using a three-day window.

Details regarding the release schedule that we describe are drawn from official documentation posted on the three credit rating agencies’ websites. An upcoming rating announcement is communicated privately to the issuer by the rating agency after the decision has been approved. This notification is intended to verify accuracy with the issuer and to eliminate risk of unintentional disclosure of confidential information in the ratings report.

Identifying and verifying that a specific trade is based on nonpublic material information is difficult. Investigators must show that a trade is conducted based on confidential information about the upcoming rating change rather than as a response to the event(s) preceding the rating change. If the informed trader is a third party seemingly unrelated to the information source or if the immediate benefits to the person suspected of disclosing the information are unclear, this task can be challenging.

There are two regulations that require rating agencies to maintain policies and procedures to prevent disclosure to third parties of pending rating actions and confidential information regarding issuers: Rule 17 g-4 and the SEC Investment Advisers Act of 1940. Consistent with these regulations, rating agencies prohibit or restrict analysts and rating committee members from trading or holding securities of the companies that belong to their employees’ areas of practice. Violation of these policies may lead to negative outcomes for rating agency employees, ranging from a written warning to loss of employment and reputational damage. These two regulations do not impose any penalties on the rating agency itself for violations of its internal policies, unless they are proven to result in violations of a federal law. In fact, the SEC cited significant problems with the enforcement of agencies’ internal policies and even found that one large agency’s procedures allowed employees to selectively disseminate information about pending rating actions (SEC 2011).

Other studies explore the reaction of CDS spreads to credit rating change announcements (e.g., Chava et al. 2012; Hull et al. 2004; Norden and Weber 2004; Norden 2017). In addition to our examination of a different security and use of a different sample composition, we focus on the drivers of price movements ahead of credit rating changes, whereas prior studies primarily focus on the predictive power of long-term changes in CDS spreads. None of the aforementioned studies investigate whether observed returns are driven by corporate news events, investor anticipation, or information leakage.

In a concurrent study, Kraft et al. (2020) examine intraday timing of S&P’s credit rating change announcements. They focus on the determinants of intraday timing, whereas we focus on the price reactions to rating changes.

See SEC (2000).

Relatedly, Michaelides et al. (2015) find that, in corrupt economies, stock markets move at least two weeks ahead of sovereign debt rating changes. Aside from institutional and regulatory differences between the two settings, Michaelides et al. do not test for investor anticipation or for the presence of other economic news events (except those that cite a rating) as possible explanations.

For example, in 2018, a credit analyst working at S&P and two friends were criminally charged with insider trading regarding the impending transaction between two paint makers, after the analyst had learned about it in confidential memos at work (Stempel 2018)

Among the 10 nationally recognized statistical rating organizations (NRSROs), the three largest agencies are S&P, Moody’s, and Fitch. As of 2016, these three held a collective global market share of roughly 95%, with S&P and Moody’s holding approximately 40% each and Fitch around 15%.

According to the TAQ User’s Guide, a Trade Correction Indicator value of “00” signifies a regular trade that was not corrected, changed, or canceled. A sale condition value of B signifies an aggregate of two or more regular trades executed at the same time. G signifies a trade not reported within 90 s of execution. J signifies a trade reported as having been executed as a block position. K signifies a specialist trade. L, O, and Z signify transactions reported to the tape at a later time. T signifies a trade executed outside market hours. W signifies a trade where the price reported is an average of the prices of transactions executed during all or any portion of the trading day.

For approximately 6% of the sample announcements, we cannot identify the exact timestamp. In order not to bias our estimates of pre-announcement returns in the direction of the rating change announcement, we assume that these announcements occur at the beginning of the trading day. Our inferences remain identical if we remove these observations from our sample.

We designate the pre-announcement period as starting at the earliest time that internal decisions for a rating action are made by the rating agencies, according to their manuals, and ending one minute before the rating action’s public announcement. The choice of windows for the leading and announcement periods are ad hoc. However, our inferences are unchanged when we use five- or 10-trading day windows for the leading period. We discuss the rating decision timeline in detail in Section 3.2.3.

For every news article that mentions a company, Ravenpack assigns a relevance score between 0 and 100, where 0 refers to cases where the firm is only mentioned in passing and 100 to cases where the firm is the subject. Von Beschwitz et al. (2015) find no significant market reaction to news with a relevance score of less than 90 and strong reaction to news with a relevance score above 90. Thus we consider articles with a relevance score of 90 or above as confounding. Our inferences are unchanged when we use 75 as the cutoff, although some of our findings become statistically significant at the 10% level rather than at the 5% or 1% level. The reduction in statistical significance levels is likely driven in part by the smaller sample size.

Our filtering is more comprehensive than that used elsewhere, both in terms of our news sources and window. For example, Holthausen and Leftwich (1986), Hand et al. (1992), Goh and Ederington (1993), Jorion et al. (2005), and May (2010) classify 45%, 53%, 30%, 23%, and 42% of their samples as contaminated, respectively.

While magnitudes and statistical significance levels vary, all of our inferences remain the same when we break the results out by rating agency.

In untabulated analyses, we also compare our results based on whether there is a transition from or to speculative grade. We find that, for issuer ratings, downgrades from investment to speculative grade are associated with a significant −1.3% mean pre-announcement return and a statistically insignificant −0.6% mean announcement period return. For instrument ratings, we continue to find insignificant results in both transitions. However, we caution that sample sizes in these analyses are small.

For example, Primary Market Corporate Credit Facility established by the Federal Reserve in response to the COVID-19 crisis is available only to investment grade issuers. See https://www.newyorkfed.org/markets/primary-and-secondary-market-faq/corporate-credit-facility-faq

Findings in some other studies contest these results. For example, Forte and Pena (2009) and Norden and Weber (2009) find that stock prices lead CDS spreads more often than the other way around.

To calculate industry returns, we exclude the sample firm and impose the same TAQ data requirements as in our main sample. We lose 164 observations across the three agencies, due to the lack of required data.

All three rating agencies in our sample operate on issuer-paid basis when assigning credit ratings in the United States. This implies that investors should not be aware of the ongoing ratings process unless the analyst or the issuer shares this information.

For example, S&P’s Corporate Ratings Criteria (2002) states: “Once the rating is determined, the company is notified of the rating and the major considerations supporting it. It is Standard & Poor’s policy to allow the issuer to respond to the rating decision prior to its publication by presenting new or additional data. Standard & Poor’s entertains appeals in the interest of having available the most information possible and, thereby, the most accurate ratings. In the case of a decision to change an extant rating, any appeal must be conducted as expeditiously as possible, i.e., within a day or two. The committee reconvenes to consider the new information. After notifying the company, the rating is disseminated in the media—or released to the company for dissemination in the case of private placements or corporate credit ratings.” The timeline is similar for Moody’s and Fitch. Details of Moody’s criteria are available at https://www.moodys.com/Pages/amr002001.aspx, and details of Fitch’s criteria are available at https://www.fitchratings.com/research/structured-finance/the-ratings-process-22-05-2019.

Our inferences are generally robust to various 20- and 50-day windows before or after the rating change announcement.

We include banking and insurance firms in this classification.

Our inferences are unaffected if we remove an S&P analyst who was fired for insider trading and is classified as Career_Path = 1.

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Titel: What moves stock prices around credit rating changes?
Publikationsdatum: 07.01.2021
Erschienen in: Review of Accounting Studies / Ausgabe 4/2021
Print ISSN: 1380-6653
Elektronische ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-020-09573-6

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