How the Market Reacts to Credit Rating Changes

ratings agencies trustTwo different reports, one by Dimensional Fund Advisors and another masters student’s thesis appear to come to different conclusions about the market impact of credit rating announcements.

In the report titled, “Credit Ratings vs. Market Risk” (June 2012), Dimensional Fund Advisors discusses the market’s reaction to the downgrade of 15 major banks by Moody’s and comes to the following conclusion:

Like the equity market, the fixed income market prices in information about credit risk instantaneously. This makes it extremely difficult for credit rating agencies to adjust their ratings in a way that fully reflects the market’s’ perception of risk.

 

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Moody’s downgrade of fifteen major banks may have been presented to the general public as significant news, but the lowered ratings had been factored in by the market well in advance of the official statement.

On the other hand, “Do Credit Rating Announcements Matter?” by Timo Brandstack concludes:

I find that during the whole observation period the CDS market (Editor’s note: CDS market is insurance against bond defaults) seems to generally anticipate and react to negative rating announcements, whereas positive rating announcements are found in general less significant.

However, the two reports in fact are not contradictory at all. In the situation discussed in Dimension Funds Advisors report, the rating agencies had put the 15 banks on a watchlist for negative downgrades four months before the official downgrade announcement. In the case where there was a warning by the credit agency prior to the downgrade, Brandstack found:

However, downgrade from the negative view watchlist does not seem to induce any effect on the market at all.  . . Furthermore, I find that the magnitude of market impact depends more on whether the rating announcement is preceded with the corresponding watchlist announcement than how many notches it moves the credit rating.

The following graphic from the Dimensional Fund Advisors report shows, the impact, or lack of impact, of the rating downgrade from Moody’s. The report stresses the fact that while the market was aware that there would be downgrade of these issuers, there was a great deal of uncertainty regarding the number of notches of the downgrade. In other words, if the market valued the view/analysis of the Moody’s rating, the price of the bonds should reflect the new rating.

The dark blue bar represents the rating before the downgrade and the light blue bar afterwards. The dark gray bar represents the price of the bond (in terms of what type of rating one would expect based on similarly priced bonds) before the downgrade. The light gray post downgrade.

For most of the issuers, the rating downgrade had no impact on price. When an issuer is on a negative watchlist, there is no real impact on the bond’s price from the downgrade. It should be noted that 75% of the time that Moody’s put an issuer on a watchlist prior to a downgrade.  For S&P there was a warning 50% of the time. The least important of the “big three” rating agencies, Fitch, issued an alert only 10% of the time.

What happens to an issuer’s bonds if they receive a downgrade without first being on a watchlist for a downgrade?  In the case of a single notch downgrade by S&P, the cost of insuring the bonds against default had an immediate rise of about 1/7th percent (15 bps). Over the next month, the impact of the downgrade seems to wear off a little with the long-term impact being about 1/10th a percent. The changes in CDS cost should translate into a similar higher yield for the bond.

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