Rating Agencies' Monitoring and Certification Services - Evidence from the Sovereign CDS Market

Abstract

This paper investigates the reaction of credit default swaps spreads to changes in rating class, outlook, and watchlist entries for sovereigns. We find a stronger response to negative outlook and watchlist changes than for actual rating class downgrades, which shows that negative outlook and watchlist changes reveal more information. Consistently, we are able to predict future negative outlook changes and negative watchlist entries from abnormal CDS movements. Abnormal credit default swaps spread responses are analyzed with an unrestricted market model, which allows a sound interpretation of the reaction while controlling for market movements. Additionally, we compare the reaction of high and low quality obligors to credit rating agencies' announcements with respect to timing and magnitude. We find more signicant reactions for low quality sovereigns with higher magnitudes before and at the announcement day, indicating higher sensitivity to rating changes compared to high quality obligors.

Keywords: Credit default swaps, Sovereign credit ratings, Credit rating agencies, Information content, Event study

JEL Classification: G10, G12, G13, G14, G20