Equity Returns Following Changes in Default Risk: New Insights into the Informational Content of Credit Ratings
50 Pages Posted: 22 Jul 2003
Previous studies report the existence of persistent abnormal negative equity returns following downgrades, and the absence of an equity reaction following upgrades. The above result is viewed as a puzzling anomaly, and there are attempts to explain it using behavioral theories. In this paper, we show that the above result is specific to the method used in previous studies to compute abnormal returns. In particular, we show that when returns are adjusted for the variation in default risk around downgrades, the abnormal negative returns in short horizons disappear. We use Merton's (1974) model to compute the default risk of firms each month. We then show that, consistent with rational behavior, firms whose default risk goes up earn higher subsequent returns than firms whose default risk goes down. We also note that many of the firms that experience a downgrade are bound to be downgraded again in the three-year period following the initial downgrade. When this fact is taken into account, any abnormal negative returns in the 2- to 3-year horizon also disappear. Our analysis has implications for the information content of credit ratings, as well as for the value that rating agencies provide to the investment community.
Keywords: default risk, Merton's (1974) model, abnormal equity returns, credit rating downgrades/upgrades, size, book-to-market
JEL Classification: G33, G14, G29
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