Asymmetric Trading Responses to Credit Rating Announcements from Issuer- versus Investor-Paid Rating Agencies

Abstract

Credit rating industry business model has traditionally been based on an ‘issuer-pays’ principle. Issuer-paid credit rating agencies (CRAs) have recently faced criticism regarding untimely releases of negative ratings adjustments, which is attributed to conflict of interest of their business model. A recent model based on ‘investor-pays’ principle is arguably free of such conflict. We examine how institutional investors respond to changes in credit ratings issued by these two types of CRAs. We find that investors react asymmetrically: they abnormally sell equity stakes around rating downgrades by investor-paid CRAs, while abnormally buying around rating upgrades by issuer-paid CRAs. Further, a dynamic trading strategy based on such trading behavior generates significant abnormal returns. Our study suggests that, through their trades, institutional investors capitalize on value-relevant information provided by both types of credit rating agencies.

Keywords: credit ratings, institutional investors, trading strategy

JEL Classification: G11, G24