The credit rating puzzle : a study on the relationship between equity returns and corporate credit ratings in the US stock market

Abstract

This study search to investigate the relationship between credit risk, measured by S&P longterm domestic issuer credit rating, and stock returns. Analyzing 3,172 companies over the period January 1985 to December 2013 we investigate if it exist a relationship using several methods. In the first part we generate portfolios sorted by credit rating, and analyze how certain firm characteristics and returns varies between good and bad rated stocks. Secondly, we are running panel data regressions on individual securities controlling for several control variables, such as book-to-market, market value of equity, and share turnover. We find a negative relationship between stock returns and credit ratings, suggesting that worst rated stocks on average yield lower returns than better-rated stocks. Market value of equity decrease monotonously as rating deteriorates. However, we also find that the credit rating effect is related to worst rated stocks. Excluding the worse rated stocks, we find no statistical evidence that there exist a negative effect, until we include BB- rated stocks. In times of recession the effect is stronger than in expansions, suggesting that credit ratings may be of more interest for investors when there exist a higher risk of financial distress. Around downgrades (upgrades) returns have a downward (upward) trend ex-ante the event. After change in credit quality, we notice returns bounce back on a level equal securities that did not experience any rating action. It is no clear explanation to this negative relationship. Existing literature suggest that majority shareholders can extract private benefits from distressed companies, buying the companies assets or output at lower price. Hence, the observed return is lower than the realized return. For smaller companies with low analyst coverage, bad news travel more slowly than in large firms with higher analyst coverage, and the underperformance can be explained due to investor’s underreaction to negative information.