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

Hopland, Alexander
Master thesis
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URI
http://hdl.handle.net/11250/224259
Date
2014
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  • Master Thesis [4207]
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.

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