Credit Ratings and the Cross-Section of Stock Returns

Abstract

Low credit risk firms realize higher returns than high credit risk firms. This effect is puzzling because investors seem to pay a premium for bearing credit risk. This paper shows that the credit risk effect manifests itself due to the poor performance of low-rated stocks during periods of financial distress at least three months before and after credit rating downgrades. Around downgrades, low-rated firms experience considerable negative returns amid strong institutional selling, whereas returns do not differ across credit risk groups in stable or improving credit conditions. Remarkably, the group of low-rated stocks driving the credit risk effect accounts for about 4.2% of the total market capitalization. Isolating the credit risk effect to a limited number of firms in a specific set of circumstance allows us to distinguish between its potential explanations. Our evidence points away from risk-based explanations, and towards mispricing generated by retail investors and sustained by illiquidity and short sell constraints.

Keywords: credit risk effect, credit rating, asset-pricing anomalies

JEL Classification: G14, G12, G11