To Change or Not to Change? The CDS Market Response of Firms on Credit Watch
45 Pages Posted: 5 Apr 2016 Last revised: 21 Jan 2020
Date Written: January 21, 2020
CDS spreads contain information about expected credit risk, but how accurate is this information when uncertainty about credit risk arises? We document that CDS spreads of firms on negative credit watch (review for downgrade) change systematically into the direction implied by the ex-ante uncertain review outcomes: they widen before reviews concluded with downgrades and tighten before reviews concluded with confirmations. Moreover, CDS spreads widen before deteriorations of corporate credit risk such as leverage, interest rate coverage and Altman Z-score that occur over the review period. Importantly, we do not find similar effects for firms’ stock returns. The evidence is novel and suggests that the CDS market not only reflects the increase in uncertainty but also accurate forward-looking information about the outcomes of the uncertainty-inducing events.
Keywords: Credit default swaps, uncertainty, informational efficiency, credit ratings, rating reviews
JEL Classification: G14, G24, G32, G33
Suggested Citation: Suggested Citation