Revisiting Post-Downgrade Stock Underperformance: The Impact of Credit Watch Placements on Downgraded Firms’ Long-Term Recovery

47 Pages Posted: 10 Mar 2011 Last revised: 7 Aug 2015

See all articles by Alfred Z. Liu

Alfred Z. Liu

University at Albany, SUNY

Jerry Sun

Invesco Advisers, Inc.

Date Written: June 30, 2015

Abstract

Prior research documents significant negative long-term stock returns following bond-rating downgrades. Some downgraded firms are placed on credit watches before downgrades, and we find that the post-downgrade stock underperformance of such firms is significantly reduced. We explore two explanations for the difference in post-downgrade stock performance that are not mutually exclusive: 1) a credit watch placement provides an early signal of the subsequent rating downgrade and gives investors more time to better understand the information content of the downgrade (the early-disclosure effect), and 2) a credit watch placement induces better recovery from credit deterioration for the downgraded firm in the long run (the recovery effect). We find that firms receiving watch-preceded downgrades show better improvements in operating profitability, financial leverage, and overall default risk, and are less likely to be further downgraded in future periods, compared with firms that are directly downgraded. Our findings suggest that the recovery effect is important in explaining downgraded firms’ performance in the long run and provide new evidence in support of the premise in the recent literature that credit watches can induce on-watch firms’ efforts to restore deteriorated credit quality.

Keywords: Credit Rating Agencies, Credit Watch, Implicit Contracting, Event Study, LT Stock Returns

JEL Classification: G14, G20, G24

Suggested Citation

Liu, Zhu and Sun, Le, Revisiting Post-Downgrade Stock Underperformance: The Impact of Credit Watch Placements on Downgraded Firms’ Long-Term Recovery (June 30, 2015). Journal of Accounting, Auditing and Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1781472 or http://dx.doi.org/10.2139/ssrn.1781472

Zhu Liu (Contact Author)

University at Albany, SUNY ( email )

Albany, NY 12222
United States

Le Sun

Invesco Advisers, Inc.

United States

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