Stock market reaction to credit rating changes: new evidence*

ABSTRACT

This study shows how stock market reacts to rating change announcements where confounding effects of information spillover from related markets are absent. Contrary to existing literature, we find that the stock market reacts positively to a rating upgrade and no response to downgrade. Our analysis shows that pre-announcement cumulative abnormal returns can significantly predict announcement period abnormal return. Finally, we document a significant reduction in information asymmetry due to rating upgrade announcements affirming the recent policy initiatives.

KEYWORDS:

• Credit rating
• information asymmetry
• cumulative abnormal return
• event study

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. Several studies have documented the information flow and linkages between stock and bond markets (Kiem and Stambaugh (1986), Campbell and Ammer (1993), d’Addona and Kind (2006), Gulko (2002), Connolly, Stivers, and Sun (2005), Alexander, Edwards, and Ferri (2000), Andersson, Krylova, and Vahamaa (2008), Baur and Lucey (2009), Kwan (1996), Blanco, Brenan, and Marsh (2005) among others).

2. In the absence of an active bond market, most of the companies borrow from the banks. These borrows can choose to get themselves rated or the lenders can request the credit rating agencies to rate the borrower. The credit rating reflects the creditworthiness of the borrowing entity. In an informationally opaque market these ratings offer additional channel of information to the investors that is certified by a credible source. Further details regarding the rating process is provided in Section 2 of the paper.

3. Theses results are derived from a very small sample of downgrades and hence, can be inconclusive.

4. Matolcsy and Lianto (1995) study Australian market, Barron, Andrew, and Stephen (1997) study the U.K., Elayan, Hsu and Meyer (2003) study New Zealand, Li, Shin, and Moore (2006) use Japanese data.

5. Early work on the announcement effect of rating changes in the U.S. includes Griffin and Sanvicente (1982), Holthausen and Leftwich (1986), Hand, Holthausen, and Leftwich (1992), Nayar and Rozeff (1994), Elayan, Brian, and Young (1996) and Dichev and Piotroski (2001).

6. Goh and Ederington (1999) shows pre-announcement abnormal returns can explain announcement day reaction following the downgrade. Jorion and Zhang (2007) shows prior rating is an important omitted variable that can significantly explain announcement period return. Other studies attempt the explain announcement period car include Li, Shin, and Moore (2006), Purda (2007), Elayan, Hsu and Meyer (2003), Creighton, Gower, and Richards (2007).

7. https://www.bb.org.bd/mediaroom/circulars/brpd/jul0506brpd06e.pdf .

8. https://www.bb.org.bd/mediaroom/circulars/brpd/may2904brpdle05.pdf .

9. http://www.thedailystar.net/news-detail-266952.

10. While the extant literature exclude financial firms but in Bangladesh the credit rating process is fairly recent and only the financial institutions were initially required to be rated. In the absence of the bond market the credit rating provides additional value-relevant information to the investors. In this sense, this credit rating change is just like another corporate announcement and not a credit event.

11. See MacKinlay (1997) for more on event-study methodology.

12. A detailed distribution of announcements with positive abnormal return can be provided upon request.

13. We thank the reviewer for suggesting us to this additional analysis.

14. Due to missing illiquidity estimates, we have excluded one firm and the sample size for Table 9 is 81 observations.