Impact of Rating Changes on Corporate Security Prices

    1           Principles

If ratings bring information about the credit quality of firms, a change in rating should lead to reassessment of the firm’s risk by market participants and therefore to changes in the prices of corporate securities such as bonds and equity issued by firm.

    2           Effect of Rating Changes on Bond Prices

2.1          Basic Viewpoint

Generally speaking, bond yields are closely correlated with ratings because the riskier a fixed income security, the higher the yield investors will require before they buy it.

2.2          Effect of Upgrade (Less Statistically Significant) and Downgrade (Statistically Significant)

An upgrade is likely to have a positive impact on bond prices while a downgrade is likely to have a negative impact on bond price. Most articles rely on event study methodologies and report a statistically significant underperformance of recently downgraded bonds. However, recently upgraded bonds tend to exhibit overperforming returns, but this result is generally less statistically significant. Note that the findings are very sensitive to the frequency of observation (monthly bond return versus daily) and the possible “contamination” of rating changes by other events impacting on bond prices. For example, if a firm is downgraded at the beginning of a month and announces a substantial restructuring during the same month, the negative price impact of the rating may be compensated for by a positive change linked to the restructuring. Overall the price may rise during the observation month although the actual event of interest (downgrade) had the expected negative effect.

    3           Effect of Rating Changes on Stock Prices

3.1          Basic Viewpoint

The impact of rating changes on stock prices is less obvious than that on bond prices. If rating changes leave the value of the firm unchanged, then equity prices should jump in the opposite direction to bond prices. However, there is no reason to believe that rating revisions should not affect the value of the firm. For example, bankruptcy costs can lead to a drop in the value of the firm as the probability of default increases and some of the value is transferred to third parties (lawyers, etc.). As a result, many articles indeed report falls in the value of equity.

3.2          Effect of Upgrade (Less Statistically Significant) and Downgrade (Statistically Significant)

A persistent finding is that downgrades affect stock prices significantly while upgrades do not. One possible reason for this could be that firm’s managers tend to divulge good news and retain bad news so that an upgrade is more likely to be expected than a downgrade. Another alternative would be asymmetric utility functions with downside risk priced more dearly than upside potential.

    4           Example

4.1          Concept Checkers in Schweser Study Notes

With respect to the effect on the price of a bond, the effect of a rating upgrade will probably:

A.       Be positive and stronger than the downward effect of a bond downgrade

B.        Be positive and weaker than the downward effect of a bond downgrade

C.        Have about the same negative effect, in absolute value terms, as a bond downgrade

D.       Be negative and about equal to that of a bond downgrade.

Answer: B

A rating upgrade will have a positive effect on the bond’s price, but the negative effect of a rating downgrade is generally stronger.

Reference:

1)         Arnaud de Servigny, Measuring and Managing Credit Risk

2)         Schweser Study Notes