Are Credit Ratings Still Relevant?

+
Sudheer Chava
Georgia Tech
Rohan Ganduri
Georgia Tech
Chayawat Ornthanalai
University of Toronto
September 2012
Abstract
We examine the pricing relevance of credit rating downgrades when the underlying
rm has Credit Default Swap (CDS) contracts trading on its debt. Using a compre-
hensive sample of credit rating changes from 1998 to 2007, we nd that, after a CDS
contract starts trading on a rms debt, the rms stock reacts signicantly less to a
credit rating downgrade. Firms with traded CDS also have a smaller stock and bond
market reaction to a credit rating downgrade than rms without a traded CDS. In addi-
tion, CDS spreads explain the cross-sectional variation in primary and secondary bond
yields better than credit ratings. Overall, we provide empirical evidence supporting CDS
market as a viable atlernative to credit ratings. An important implication of our study
is that regulators should also focus on improving the transparency in CDS market rather
than solely addressing the conicts of interest inherent in the business models for rating
agencies.

Sudheer Chava can be reached at Scheller College of Business at the Georgia Institute of Technology,
800 W. Peachtree St NW, GA 30309-1148; Phone: 404-894-4371; Email: sudheer.chava@mgt.gatech.edu.
Rohan Ganduri can be reached at Scheller College of Business at the Georgia Institute of Technology, 800 W.
Peachtree St NW, GA 30309-1148; Phone: 404-894-4371; Email: rohan.ganduri@mgt.gatech.edu. Chayawat
Ornthanalai can be reached at Rotman School of Management at the University of Toronto, 105 St.George
St, Toronto, ON, Canada, M5S 3E6; Phone: 416-946-0669; Email: chay.ornthanalai@rotman.utoronto.ca.
We would like to thank Robert Jarrow, Narayan Jayaraman, Stuart Turnbull, seminar participants at Georgia
Tech, Southern Methodist University, University of Alberta, University of Oklahoma, the EFA 2012 Confer-
ence, and the 23rd Derivatives Conference at FDIC for helpful comments and suggestions. We are responsible
for all errors.
1 Introduction
Credit rating agencies that specialize in assessing the credit worthiness of bond issuers are
an integral component of the nancial landscape. Investors, regulators, and managers have
historically relied on credit ratings even though they have been frequently criticized for both
their accuracy and the conicts of interest inherent in the agencies business model (see White
(2010)). For instances, credit rating agencies were blamed for their slow response in predicting
corporate defaults (e.g., Enron, Worldcom), and more recently for their role in the recent
subprime mortgage crisis. Becker and Milbourn (2011) and Bolton, Freixas, and Shapiro
(2012) provide theoretical and empirical evidence of conicts of interest within the credit rating
industry that may result in inecient ratings with decreasing ability to predict default. In a
similar vein, Benmelech and Dlugosz (2009) provide evidence that suggest ratings shopping
by debt issuers during the recent nancial crisis. Due to overwhelming criticisms, legislators
and regulators have proposed numerous reforms to reduce the over reliance on credit ratings.
1
One reason the reliance on credit rating agencies may have persisted so long, even though
regulators may be cognizant of the shortcomings of the credit rating agencies, is the perceived
lack of viable alternatives to credit ratings. However, recent studies by Flannery, Houston,
and Partnoy (2010) and Hart and Zingales (2011) provide compelling arguments supporting
the use of credit default swaps (CDS), a market-based benchmark of a rms default risk,
as viable alternatives to credit ratings.
2
Similarly, Hull, Predescu, and White (2004), and
Norden (2011) show that CDS spreads anticipate credit rating downgrades, and there exists
some evidences that CDS spreads lead the stock (Acharya and Johnson (2007)) and bond
market (Blanco, Brennan, and Marsh (2005)) in information discovery. Motivated by these
studies, we examine whether stock and bond markets perceive credit rating announcements
1
For example, the Dodd-Frank Act of 2010 mandates that federal regulators remove references to credit
ratings from their rules. Securities and Exchange Commission (SEC) has recently proposed rules to eliminate
certain aspects of regulatory reliance on credit ratings and in a similar vein Federal Deposit and Insurance
Corporation (FDIC) has proposed rules that will reduce large U.S. banks reliance on credit ratings when
evaluating the risk of their assets.
2
Flannery, Houston, and Partnoy (2010) evaluate the viability of CDS spreads as substitutes for credit
ratings and support using CDS for regulatory purposes. Hart and Zingales (2011) suggest basing capital
requirements of large nancial institutions on their CDS spreads.
1
to be less pricing relevant when the underlying rm has a CDS traded on its debt. Our main
hypothesis is that if the market perceives CDS as a viable alternative to credit ratings, then
stock and bond price reactions to the credit rating changes will be signicantly attenuated in
the presence of CDS trading.
In contrast to credit ratings, CDS are standardized contracts and relatively more liquid
than corporate bonds. Though a relatively recent nancial innovation, CDS markets have
experienced a tremendous growth with the outstanding notional amount, increasing from $8
trillion in 2004 to $62 trillion in 2007. Recent studies also nd that CDS spreads contain
relevant information not previously available in the credit risk market. Ericsson, Jacobs, and
Oviedo (2009) show that CDS spreads are a purer measure of a rms default risk than
corporate bond spreads. Jarrow (2011) argues that CDS allows investors to better hedge their
credit risk, thus leading to a more optimal allocation of risks in the economy.
We use a comprehensive sample of credit rating change announcements from the three
major NRSROs - Standard and Poors, Moodys and Fitch, from 1998 to 2007.
3
We obtain
CDS data from the CMA Datavision database and consider the date of the rst available
quote for each rm as the start of active trading in CDS tied to that rms debt. We also
supplement the CMA database with CDS quotes extracted from Bloomberg. In the case when
Bloomberg reports CDS quotes earlier than CMA, we consider the earlier date as the date
of CDS introduction. Consistent with prior literature, we nd that stock and bond markets
perceive credit rating announcements to have pricing-relevant information.
4
That is, stock and
bond prices react signicantly negatively to credit rating downgrades. However, we nd that
when CDS contracts are introduced on the rms debt, the stock and bond market reaction to
3
Several government interventions and regulatory reforms in the nancial markets took place after 2007.
Furthermore, the aftermath of subprime crisis may have resulted in reputation loss for some credit rating
agencies. In order to avoid confounding our results with the subprime crisis and the associated regulatory
interventions, we focus our attention to the period 1998-2007.
4
Holthausen and Leftwich (1986), and Hand, Holthausen, and Leftwich (1992) respectively, show abnormal
stock and bond market returns for credit rating downgrades, but not to upgrades. Similarly, Dichev and
Piotroski (2001) nd negative abnormal returns in the rst year following downgrades but no reliable abnormal
returns following upgrades. Jorion, Liu, and Shi (2005) argue that the FD regulation might have bestowed
upon the credit rating agencies and informational advantage owing to the exemption of the rating agencies from
FD regulation. As a result, they nd that the market reacts to both upgrades and downgrades signicantly
in the post FD period of 2001.
2
credit rating downgrades is muted. Using both univariate and regression analyses, we nd that
rms with traded CDS contracts react signicantly less to rating change downgrades relative
to rms without traded CDS contracts. On the other hand, consistent with Holthausen and
Leftwich (1986) and Hand, Holthausen, and Leftwich (1992), we nd insignicant stock price
reactions to rating change upgrades for rms with and without CDS contracts. Our nding
conrms that upgrades generally are not informative.
It is possible that rms with traded CDS are dierent from rms without traded CDS on
some observable or unobservable dimensions. We address this concern by restricting attention
to rms that have CDS traded at some point during the sample period. This allows us to
compare the stock market reaction of individual rms to credit downgrades before and after
CDS trading. Consistent with cross-sectional results, we nd a signicant reduction in the
rms stock price reactions after CDS contracts started trading on the rms debt.
Another concern with our analysis so far is the potential for endogeneity. Firms with
and without CDS trading may have dierent characteristics. Similarly, the onset of CDS
trading on a rm may be driven by time-varying risk factors. We demonstrate that such
endogeneity concerns are not driving results by implementing a propensity score matched
sample analysis (see Rosenbaum and Rubin (1983)). We show that a control group of non-
traded-CDS rms with similar characteristics (based on Ashcraft and Santos (2009)) to traded-
CDS rms, react signicantly more negatively to credit rating downgrades, than the traded-
CDS rms. In contrast, both control and treated CDS rms react negatively and signicantly
to the credit rating downgrades before the introduction of CDS, but the dierence is not
statistically signicant.
We next analyze the bond market reaction to credit rating downgrade announcements.
Because of the illiquidity and paucity in corporate bonds data, the number of unique rms
in our sample falls drastically. Nevertheless, the cross-sectional univariate test conrms our
nding in the equity market. We nd that bond prices of traded-CDS rms react signicantly
less to credit rating downgrades than for non-traded-CDS rms. Bond yield regressions show
3
that CDS spreads are an important determinant of bond yields and explain the cross-sectional
variation in bond yields better than credit ratings. One implication is that CDS spreads can
directly aect the rms cost of debt. The evidence indicates that in the presence of traded
CDS, credit ratings are less important in explaining the cross-sectional variation in both the
primary and secondary bond yields.
Flannery, Houston, and Partnoy (2010) argue that CDS spreads are viable substitutes
for credit ratings because they incorporate new information about the underlying rm more
quickly than credit ratings. Following their argument, we examine whether information de-
rived from the CDS market can predict future downgrades. Using a nonparametric method,
we back out rating levels implicit in CDS spreads and show that CDS-implied ratings started
increasing at least 180 days prior to a downgrade. Finally, we estimate the likelihood of a
rating change event using the stratied Cox proportional hazard model. Estimation results
show that the change in CDS spreads as well as the level of trading activity signicantly
predict future downgrades.
To our knowledge, our paper is the rst to examine the impact of CDS introduction
on the pricing relevance of credit rating agencies. Previous studies such as Holthausen and
Leftwich (1986), Hand, Holthausen, and Leftwich (1992), and Dichev and Piotroski (2001)
unanimously conrm that rating downgrades contain relevant information to the bond and
equity holders. However, no studies exist that examine the impact of credit derivatives on the
pricing relevance of credit rating agencies. More recently, Jorion, Liu, and Shi (2005) show
that the informativeness of credit rating announcements increases in the post reg-FD period
due to the private information made available to credit rating agencies. We show that even
after reg-FD, the onset of CDS trading has signicantly decreased the importance of these
rating change announcements.
5
Our results suggest an important policy implication. Legislators and regulators have in-
vested most of their energy in crafting proposals that attempt to reform the credit rating
5
The Dodd-Frank act mandated that the credit rating agencies exemption to the FD regulation is removed.
4
agency industry and reduce the reliance of regulators and investors on credit rating agency
opinions. The lack of viable alternative to credit ratings has been cited as the main reason
for the over reliance on credit rating agencies. Our ndings provide strong empirical evi-
dences supporting the view advocated by Flannery, Houston, and Partnoy (2010) and Hart
and Zingales (2011) that the market already perceives CDS as a viable alternative to credit
ratings. Our results show that stock and bond markets do not perceive credit ratings to be
as informative when a market based benchmark for a rms default risk is available through
the CDS spread. In this context, it may be more benecial for regulators (and investors)
to design policies that promote transparency and liquidity in the CDS market, rather than
focusing solely on reforming the credit rating industry.
The rest of this paper proceeds as follows. Section 2 describes the data. Section 3 presents
the methodology and the main empirical results. Section 4 provides results from extending our
analyses to the corporate bond market. Section 5 examines economic channels that explain
why stock and bond prices react signicantly less to credit rating downgrades in the presence
of CDS contracts. Finally, Section 6 concludes.
2 Data and descriptive statistics
We use CMA Datavision database (CMA) to identify all rms for which we observe CDS
quotes on their debt. CMA Datavision is consensus data sourced from 30 buy-side rms,
including major global investment banks, hedge funds and asset managers. Mayordomo,
Pena, and Schwartz (2010) compare the data qualities of the six most widely used databases:
GFI, Fenics, Reuters, EOD, CMA, Markit and JP Morgan, and nd that the CMA database
quotes lead the price discovery process. The CMA database is widely used among nancial
market participants and since October 2006, it has been disseminated through Bloomberg.
We further ensure the accuracy in the coverage of CDS quotes by augmenting the original
CMA database with the CDS data obtained from Bloomberg. The earliest quote were then
5
taken as the rst sign of active CDS trading on a rms debt.
Data on bond ratings was gathered from the Mergent Fixed Income Securities Database
(FISD) database. FISD is a comprehensive database consisting of issue details on over 140,000
corporations, U.S. Agencies, and U.S. Treasury debt securities. FISD contains detailed infor-
mation for each issue such as the issuer name, rating date, rating level, agency that rated the
issue, and credit watch status etc. We include only ratings issued by the top three NRSROs -
S&P, Moodys and Fitch. We restrict our sample to U.S. domestic corporate debentures and
exclude Yankee bonds, and bonds issued via private placements. We also consider only the
issuers whose stocks are traded on either the NYSE, AMEX, or NASDAQ. The nal sample
consists of about 85% of the ratings reported in the FISD database. Approximately 15%
of the ratings are from Fitch, and the remaining ratings are split evenly between S&P and
Moodys.
6
We consider a rating change for an issuer as one observation. When there are rating changes
on multiple bond issues for an issuer on the same day, we use the issue with the greatest
absolute rating scale change because such change is likely to create the strongest impact
on bond and stock prices. The FISD ratings database has a variable called reason which
provides the reason for the rating change on an issue. About 4.5% of the total rating change
reasons are IR (Internal Review), while about 2% are AFRM (Armed). We consider
only the rating change reasons that are either DNG (downgrade) or UPG (upgrade)
which constitute about 90% of the total rating changes. As robustness checks, we repeat
all the analyses using all thereason types and obtain the same conclusions. The primary
sample is from January 1998 to December 2007 and consists of 4195 downgrades and 1856
upgrades; we refer to it as the Full sample for the remaining part of this paper. The full
6
We provide the mapping of the rating codes to the cardinal scale in Appendix A. Moodys uses code from
Aaa down to C to rate bonds whereas S&P rates bonds from AAA down to D. Within the 6 classes - AA to
CCC for S&P and Aa to Caa for Moodys, both rating agencies have three additional gradations with modiers
+,- for S&P and 1,2,3 for Moodys (For example AA+, AA, AA- for S&P and Aa1, Aa2, Aa3 for Moodys).
We transformed the credit ratings for S&P (Moodys) into a cardinal scale starting with 1 as AAA(Aaa), 2
as AA+(Aa1), 3 as AA(Aa2), and so on until 23 as the default category. As Fitch provides three ratings for
default, we follow Jorion, Liu, and Shi (2005) and chose 23 instead of 22 for the default category which is the
average of three default ratings, i.e. DD.
6
sample consists of 1293 unique rms, of which 390 have CDS trading at some point during
the sample period.
Table 1 summarizes the number of upgrades and downgrades along with the size of their
rating changes over each year. There are about 2.2 downgrades for every upgrade which is,
more or less consistent with the previous studies.
7
We observe clustering of upgrades and
downgrades in certain years over the 15-year period. We nd that 31% of all downgrades
occurred between 2001 and 2002, whereas 33% of all upgrades occurred between 2006 and
2007. These ndings can be attributed to the economic downturn in 2001, and the historically
low market volatility, i.e. VIX level, in 2006 and 2007, respectively. The size of the rating
change is the absolute value of the change in rating scale as dened in the previous section.
Table 1 shows that the average size of rating change doesnt vary signicantly over the years.
There are 813 downgrades and 473 upgrades during when the underlying rms have CDS
contracts traded. On the other hand, there are 3382 downgrades and 1383 upgrades during
when the underlying rms do not have CDS contracts traded. For downgrades (upgrades),
the mean size of absolute rating change for an issue without CDS trading is 1.68 (1.32) and for
an issue with CDS trading is 1.44 (1.25). Table 1 shows that the start dates of CDS trading
in our sample begin in 2002 where we observe only 12 downgrades on rms that have CDS
contracts traded. Nevertheless, the number of rms that have CDS contract traded increase
signicantly in subsequent years. In fact, Table 1 shows that the number of downgrades on
rms with and without CDS contracts traded are roughly equal after 2005.
Jorion, Liu, and Shi (2005) show that rating agencies have a weaker impact on stock returns
during the pre-FD period compared to the post-FD period. Therefore, we also consider rating
changes that took place between 2001 and 2007. We refer to this subsample as the Year
01-07 in Table 1. The use of this subsample helps us focus more on recent rating changes
as well as avoiding the potential contamination from the pre-FD (Fair Disclosure) regulation
period, i.e. prior to September 2000.
7
Our number is closer to Dichev and Piotroski (2001) who report twice as many downgrades as upgrades
over the sample period of 1970 to 1987. Whereas Jorion, Liu, and Shi (2005) report 4 downgrades for every
upgrade from 1998 to 2002.
7
Many of the rms in our sample never experience CDS trading over the 1998-2007 period.
It is possible that rms with and without CDS contracts traded on their debts are inherently
dierent. In order to control for the dierences between these two rm types, we consider a
subsample of rms for which CDS starts trading at some point during our sample period. More
specically, we compare their stock reactions to rating change announcements made between
their pre and post CDS trading periods. We refer to this sample as the Traded-CDS. The
mean size of rating change for the Traded-CDS sample is 1.48 before CDS trading starts
and 1.40 after CDS trading starts.
We further rene the Traded-CDS sample by looking at a shorter time period. We
consider 3 years prior and 3 years post of the date when CDS started trading on a rms
debt. this subsample allows us to test for the robustness of our results using a balanced
panel dataset. We refer to this subsample as the Traded-CDS Balanced". Table 1 shows
that the sizes of rating changes for theTraded-CDS Balanced sample before and after the
introduction of CDS are very similar for both downgrades and upgrades.
Table 2 reports the distribution of absolute magnitude of rating changes for pre and post-
CDS trading periods. In panel B, we report absolute rating changes for within class, across
class, and across investment grade rating changes. A rating change is dened as within
class if it is within the same alphabet letter (e.g., A+, A, A-). All other rating changes are
classied as across class. Among the across-class rating changes, those that change between
investment grade to speculative grade, and vice versa, are considered across investment
grade change.
Appendix A summarizes rating classes that belong to the investment and speculative
grades. Previous studies (see Jorion, Liu, and Shi (2005), and Holthausen and Leftwich
(1986)) show that across-investment-grade change is likely to be important due to regulatory
reasons that prevent certain investment institutions from holding speculative grade bonds in
their portfolio. Hence, a rating change from investment grade to speculative grade will elicit a
stronger price reaction compared to a rating change within investment grade. Overall, Tables 1
8
and 2 show that the pre-CDS rating events and the post-CDS rating events are roughly similar
in terms of magnitude of the absolute value of rating scale change and types of rating change
events.
3 Stock price reaction to rating changes
3.1 Methodology
We study changes in daily abnormal stock returns on the date of rating change announcements
in the pre- and post-CDS periods. We carry out the analysis separately for upgrades and
downgrades. We dene daily abnormal stock return as the dierence between the raw return
and the return tted from the following market model
1
it
= c
i
+ ,
i
1
mt
+ c
it
.
where 1
it
is the raw return for rm i on day t. and 1
mt
is the value weighted NYSE /AMEX
/NASDAQ index return. The daily abnormal return, 1
it
. is then computed using
1
it
= 1
it
(^ c
i
+
^
,
i
1
mt
).
where ^ c
i
and
^
,
i
are OLS estimates of c
i
and ,
i
. We estimate ^ c
i
and
^
,
i
using a rolling window
over a period of 255 days from -91 to -345 relative to the event date.
8
We examine whether the mean cumulative abnormal returns (CAR) around the event
period is signicantly dierent from zero. Following Holthausen and Leftwich (1986), we
compute CAR using the three-day window centered on the announcement date. That is,
C1
i
(1. 1) =
P
+1
t=1
1
it
. We test the null hypothesis that the sample mean of CAR is
equal to zero. There are three potential econometric concerns with our methodology. First, the
prediction of security returns using the market model may be imprecise. Kothari and Warner
8
Our results are robust to shorter estimation windows.
9
(2007), however, show that short horizon event studies such as ours is not highly sensitive
to the assumption of cross-sectional or time-series dependence of abnormal returns as well
as the benchmark model used for computing abnormal returns. Nevertheless, for robustness
check, we verify that the results remain qualitatively similar when dening abnormal returns
as the market adjusted return, i.e. 1
it
= 1
it
1
mt
. The second econometric concern is the
assumption that abnormal returns in the cross-section of rms are independent. We address
this issue by repeating our analysis using standardized CAR instead of CAR and obtain the
same conclusions. Finally, our third concern is that there could be other factors aecting the
rms during the event period. We tackle this issue in Section 3.3 using a regression analysis
controlling for various factors that could aect stock price reaction to rating changes.
3.2 Univariate analysis
Full Sample
Table 3 reports the mean of CAR for the pre- and post-CDS trading periods. The results in
Panel A is based on the Full-sample. As described in Section 2, this sample contains traded-
CDS rms as well as non-traded-CDS rms. Traded-CDS rms are those that eventually have
CDS traded at some point during our sample period. On the other hand, non-traded-CDS
rms are those that never experience CDS trading in our sample, which is from 1998 to 2007.
Consistent with previous studies (Holthausen and Leftwich (1986), Hand, Holthausen, and
Leftwich (1992), and Goh and Ederington (1993)), we nd that stock prices react signicantly
to downgrades (-3.95%) but not to upgrades (0.06%). Prior studies argue that rms are
reluctant to release bad news whereas they voluntarily release good news to the market.
The market therefore perceives the information content in downgrades as more valuable than
upgrades because rating agencies often expend more resources in detecting a deterioration in
credit quality. Furthermore, rating agencies are averse to reputational risk. The loss to their
reputation may be greater if they fail to detect failing credit conditions rather than letting
improvements in credit quality go undetected.
10
Table 3 shows that the mean CARs over the three-day window around rating downgrades
is negative and signicant at the 1% level for the pre- and post-CDS periods. However, the
magnitude is signicantly weaker for the post-CDS period. The mean CAR in the post-CDS
period is -1.22% compared to -4.61% in the pre-CDS period. The dierence in CAR between
these two groups is -3.39% and is statistically signicant at the 1% level. Panel B of Table 3
shows the results using the sample period 2001-2007. This subsample excludes the period prior
to the implementation of the Fair Disclosure (FD).
9
Jorion, Liu, and Shi (2005) show that the
market reaction to rating downgrades is signicantly stronger after 2001 when the regulation
FD is implemented. Jorion, Liu, and Shi (2005) argue that the stronger stock reaction to
rating downgrades from 2001 onwards is due to the exemption of the rating agencies from the
FD regulation. Such exemption puts rating agencies in an advantageous position because it
allows them to continue accessing private information from rms that they were rating. By
eliminating the 1998-2000 period, we eliminate all the rating events in the pre-FD regulation
period. Panel B of Table 3 shows that the results that we obtain earlier hold. The dierence in
the mean CARs between pre-CDS and post-CDS periods is -3.41%. This value is statistically
signicant at the 1% level. Even though the mean CARs for upgrades is not signicant for
both periods, it is worth noting that market reaction to upgrades is smaller in the presence
of CDS trading.
Previous studies demonstrated that across investment grade rating changes often generate
stronger price reactions than within investment grade rating changes. Panel B of Table 2
shows that the fraction of across-investment-grade rating changes in the post-CDS is 18.20%
which is higher than 9.17% observed in the pre-CDS period. Therefore, based on the sample
distribution of across-investment-grade rating changes, we would expect to nd stronger price
reactions in the post-CDS period rather than in the pre-CDS period. However, the results
in Table 3 suggest the opposite. Stock prices react less to credit rating changes after the
introduction of CDS. Consequently, the results in Table 3 are likely to understate the impact
that the introduction of CDS has on the relevance of rating changes because they are based
9
The implementation of the Fair Disclosure (FD) regulation took place on October 23, 2000.
11
on all types of rating changes. All in all, the results in Table 3 are in line with our hypothesis
that rating changes are less informative when CDS contract is traded on a rms debt.
The sample that we use to generate the above results consists of rms that have CDS
contracts traded (traded-CDS rms) as well as those that never have CDS contracts traded
on their debts (non-traded-CDS rms). It is possible that traded-CDS and non-traded-CDS
rms are inherently dierent and hence may not be comparable. To tackle this problem, we
repeat the analyses using only traded-CDS rms. We discuss the results in the next section.
Traded-CDS rms sample
Table 4 presents the univariate results for the Traded-CDS sample. Panel A of Table 4
reports the results for the period 1998 to 2007. Conrming our previous results, Table 4
indicates that stock price reacts signicantly weaker to credit rating downgrades in the post-
CDS period. We nd the dierence of -2.21% in the mean CAR between the pre-CDS and
post-CDS periods. This magnitude is statistically signicant at the 1% level.
In Panel B, we consider a more balanced time period of the Traded-CDS sample. This
corresponds to 3 years prior and 3 years post of the date when CDS trading started. Again,
the results are remarkably consistent. The mean CAR between the pre- and post-CDS trading
groups is -1.80% and is statistically signicant at the 1% level. To summarize, we nd that
even after controlling for the potential selection bias that traded-CDS rms are inherently
dierent from non-traded-CDS rms, our conclusion remains intact.
3.3 Regression analysis
In this section, we employ multivariate regressions to control for factors that could aect
the stock price reaction to rating changes. In line with previous studies (see Holthausen
and Leftwich (1986) and Jorion, Liu, and Shi (2005)), we run the regressions separately for
12
upgrades and downgrades. We report the results in Table 5. We estimate the following model
C1
i
= ,
0
+ ,
1
d1q:cdc
i
+ ,
2
dC1o
i
+ ,
3
occ|c1i,,
i
+ ,
4
1:1c:
i
(1)
+,
5
1i::Co:t:o|:
i
+
i
.
where for bond i, CAR is the 3-day cumulative abnormal return centered on the date of rating
change announcements, i.e. event window (-1,1). d1q:cdc is a dummy variable equal to one if
a bond is revised from investment grade to speculative grade or vice-versa and zero otherwise.
dC1o is a dummy variable equal to one if the rating change takes place when CDS trades on
the underlying rm and zero otherwise. occ|c1i,, is the absolute value of rating change in
cardinal value. 1:1c: is the natural logarithm of the number of days between the previous
rating change in the same direction for the same bond but by another rating agency. The
number of days is set to 60 if both rating agencies rate on the same day or if the rating by the
second rating agency is in the opposite direction or if the rating change by the other rating
agency is more than 60 days. 1i::Co:t:o|: include, Leverage dened as the total debt over
assets; Prot Margin dened as net income over sales; Log Market Value dened as the natural
logarithm of the market value of the entity.
Among the variables in equation (1), we are most interested in the coecient of dC1o
because it captures the informational impact of rating changes in the presence of CDS trading.
If rating changes are less informative in the presence of CDS trading, we would expect the
coecient of dC1o to be positive for downgrades and negative for upgrades. As documented
in prior studies, we expect that the larger the coecient of occ|c1i,,, the larger is the stock
price response. We therefore expect this coecient to be negative for downgrades and positive
for upgrades.
Because there are regulations limiting the amount of speculative grade bonds that certain
institutions can hold, we expect a strong price reaction when a bond rating is revised from
investment grade to speculative grade or vice-versa. This eect is captured by the coecient
on the variable d1q:cdc; we expect it to be negative for downgrades and positive for upgrades.
13
The 1:1c: variable tests for the price impact when a rating change made by one rating
agency is in the same direction as the rating change issued by the previous rating agency.
If the period between in-the-same-direction rating changes is long, then we expect the later
rating change to convey new information to the market. On the other hand, the longer period
could also indicate that the rating changes are issued following other news events. Such rating
changes would then appear to be less informative since their relevance is superseded by the
prior information releases. Consequently, the sign on the coecient of 1:1c: is ambiguous.
For the control variables, we expect a negative (positive) coecient for downgrades (upgrades)
on the leverage variable and positive (negative) coecient for downgrades (upgrades) on the
prot margin variable. The sign for the log market value variable is ambiguous. Large rms
typically have higher media and analyst coverage and hence a rating change for them can
most likely be preempted by other news events thereby reducing the informational value of
the rating change. On the other hand, large rms are more widely held, it is therefore possible
to see a stronger market reaction when rating changes convey new information about them.
Table 5 reports the results for the above multivariate regression analysis separately for
downgrades and upgrades. We report the results for four samples: the full sample (Full), the
2001-2007 sample (01-07), the traded-CDS rms sample (FullTrdCDS), and the balanced
time period of traded-CDS rms (BalTrdCDS). The denitions of these four samples are
as dened in Section 2. All standard errors are clustered at the rm level. The coecients
on dC1o are all positive and they are signicant at the 1% level. As for upgrades, the
coecients on dC1o are mostly negative but not signicant except for the BalTrdCDS
sample. These results conrm that the average stock price reaction to rating changes is
weaker after the introduction of CDS when compared to the period before the introduction of
CDS. The coecient on 1:1c: is positive and signicant for three and two out of the four
samples for downgrades and upgrades respectively. This suggests that a rating downgrade
issued immediately following a downgrade by another agency contains less information. On
the other hand, for upgrades, rating changes in the same direction seem to provide new
information to the market or by possibly reinforcing the good credit quality of the rm.
14
Finally, we verify that our results remain intact when the rm xed-eects are included in the
full sample regression.
3.4 Matched sample analysis
It is possible that the timing of CDS introduction is endogenous. CDS contracts may have
been introduced during a period when the rms credit quality improves. Similarly, there
could be other time-varying risk factors that inuence the introduction of CDS contracts on
a rms debt. In this section, we address the endogeneity concern that traded-CDS rms
are dierent from non-traded-CDS rms on some observable characteristics (for examples,
size, leverage, etc.). We address this concern using a matched sample analysis. We match
each traded-CDS rm with a non-traded-CDS rm on several observable dimensions similar
to Ashcraft and Santos (2009)). The traded-CDS rms constitute the treated group whereas
the matched non-traded-CDS rms constitute the control group. The matching is done at
the start of CDS trading. The matched control group is assigned counterfactual CDS trading
start dates. Following this approach, we can answer the counterfactual question of how would
the stock prices of a rm in the control group react to the rating change announcements when
CDS is introduced. Such analysis controls for time-varying risk factors and the endogeneity
in the timing of CDS introduction.
The typical problems encountered with matched sample analysis is that the control group
and the treated group may not have substantial overlaps. Also, if the dimensions upon which
the rms have to be matched are large, we may end up with a very small number of observations
for the control group. In order to mitigate the above problems, we use a propensity score
matching method (Rosenbaum and Rubin (1983)) which can incorporate a large number of
matching dimensions. Using the entire sample of rms in our data, we estimate a probit
model where the dependent variable is a dummy variable equal to 1 if the rms CDS starts
to trade in the current quarter and is 0 otherwise. We estimate the probability of having
a CDS market with a probit model, using the one-quarter-lagged covariates from Ashcraft
15
and Santos (2009). These covariates are: equity analyst coverage; log stock market volatility;
dummy variable equal to one if the rm has a credit rating; log sales; debt-to-assets; book-to-
market; and log equity market trading volume. For each CDS rm, we identify a non-CDS rm
with the closest propensity score. While matching, we make sure that the propensity score
of the matched non-traded-CDS rm is within 10% of the propensity score of the matched
traded-CDS rm. The matching technique used for this is the nearest neighborhood caliper
matching approach of Cochran and Rubin (1973). There are many more rms without CDS
trading than rms with CDS trading in our sample and hence we face a trade-o between bias
and eciency in our analysis. In order to increase our sample of matched rms (see Dehejia
and Wahba (2002), and Smith and Todd (2005)), we allow each non-traded-CDS rm to serve
as a match for up to three rms with traded CDS. This exercise leaves us with a sample of
176 traded-CDS rms matched to 92 unique non-traded-CDS rms.
We report the univariate results for the matched sample analysis in Table 7. Panel A
considers the entire sample period, 1998 to 2007, while Panel B reports results for the balanced
sample period covering 3 years before to 3 years after of the rst date of CDS trading. We
winsorize our data at the 1% CARs cuto to eliminate any remaining extreme outliers from
the matching procedure. The results clearly suggest that the market reaction to downgrades
for the non-traded-CDS rms is stronger and signicant in the post-CDS period compared to
the traded-CDS rms. Looking at Panel A, the dierence in mean CAR between the treated
and control groups is 2.94% for downgrades and statistically signicant at the 1% level. In
the pre-CDS period, this dierence is small and insignicant indicating that the stock prices
of the control group and the treated group react similarly to downgrades. However, upon the
onset of CDS trading, there is a signicant dierence in the extent to which these rms stock
prices react to rating downgrades. Overall, from the univariate perspective, we show that
after controlling for changing risk factors, and cross-sectional dierences between traded and
non-traded-CDS rms, stock price reacts signicantly less after the onset of CDS trading on
the underlying rms.
16
In Table 8, we run a regression similar to Table 5 for the matched sample. However, this
time, our variable of interest is the dierence-in-dierence (DID) estimator which measures the
eect of the introduction of CDS controlling for other time-varying factors. We introduce two
new variables namely, dCo:t:o| - a dummy variable equal to 1 for a rm in the control group
which is matched with a traded-CDS rm and value zero otherwise, and dC1o dCo:t:o|
- an interaction term between the dummy variables dC1o and dCo:t:o|. We estimate the
following regression model
C1
i
= ,
0
+ ,
1
d1q:cdc
i
+ ,
2
dC1o
i
+ ,
3
dCo:t:o| + ,
4
dC1o dCo:t:o| +
+,
5
occ|c1i,,
i
+ ,
6
1:1c:
i
+ ,
7
1i::Co:t:o|:
i
+
i
.
The coecient of the interaction term dC1o dCo:t:o| is the DID estimator which is of the
following form
,
4
= 1
z
(C1[dC1o = 1. dCo:t:o| = 1) 1
z
(C1[dC1o = 0. dCo:t:o| = 1)
1
z
(C1[dC1o = 1. dCo:t:o| = 0) 1
z
(C1[dC1o = 0. dCo:t:o| = 0).
(2)
Note that 1
z
[ ] is the expectation operator conditional on the information set 2 which
represents the control variables. Equation (2) shows that after controlling for various factors,
if the informational content of rating changes decreases in the post-CDS period then the
sign on the DID coecient should be negative for downgrades and positive for upgrades. As
expected, we nd that the sign on the coecient of the DID estimator is in line with our
expectation and is signicant for the full and the balanced sample for downgrades. Overall,
matched sample univariate and DID regression results clearly suggest that the information
content in rating announcements has decreased for downgrades after the onset of CDS trading
even after controlling for potential time trends.
17
3.5 Robustness tests for stocks
We ran a series of robustness tests to our stock return analyses. We replicate the univariate
analysis, the regression analysis, and the matched sample analysis using abnormal returns
dened as the excess return over the market return and nd qualitatively the same results.
If the abnormal returns across rms are not independent, the cross-sectional abnormal
returns may not average out to be zero. This problem can be alleviated by using standardized
CAR (SCAR) instead of CAR. We dene SCAR as oC1
i
(1. +1) =
CAR
i
(1;+1)
(AR
i
)
p
3
, where
o(1
i
) is the standard deviation of the one-period mean abnormal return, and the factor of
_
3 accounts for the length of the event window (-1,+1) which is equal to 3 days. We carry
out all the analyses using SCAR instead of CAR as a measurement of abnormal returns and
obtain the same conclusions.
In order to rule out the possibility that our results are due to outliers, we winsorize each of
the CAR and SCAR specications at the 1%. We also calculate the dierence in the mean of
stock price reactions between the pre- and post-CDS groups using the bootstrapping method.
In both cases, we nd that the results do not change qualitatively. In addition, we also conduct
various other subsample analyses based on credit rating agencies, industry type, within-class
rating change, across-investment-grade rating change and nd that our results are robust.
Apart from the matched sample analysis described in Section 3.4, we apply the placebo
test test to further rule out a concern that our results are related to changes in certain market
conditions over time, e.g. changes in volatility. To do this, we rst generate random CDS
introduction dates. After, we apply the standard event study to these randomly generated
pre- and post-CDS periods. We nd that the dierence in the stock price reactions between
these pseudo pre- and post-CDS periods is not signicantly dierent from zero. Overall, using
a host of robustness tests, we conrm that the abnormal stock return around credit rating
downgrades is signicantly weaker for rms with traded CDS compared to rms without
traded CDS.
18
4 Bond price reaction to rating changes
In this section, we analyze the bond market reaction to the credit rating downgrade announce-
ments.
4.1 Corporate bond data
We obtain corporate bond data from TRACE. The data set contains individual bond trans-
action starting from July 1, 2002. The TRACE database covers a large cross section of daily
bond prices compared to the other commonly used Mergent FISD database which consists only
of trades carried out by large U.S. insurance companies. The database reports the transaction
date, time, price, yield, and size of the executed trades. Other information includes bond
identication (CUSIP) and individual trade identication. We apply a number of standard
lters to the data set. Following Bessembinder, Kahle, Maxwell, and Xu (2009), we eliminate
trades that have been canceled, corrected, and trades that have commissions. Elimination of
canceled trades involves removing the original trade as well as the reported reversal trade.
Bessembinder, Kahle, Maxwell, and Xu (2009) show that eliminating non-institutional trades
from the TRACE data increases the power of the test for detecting abnormal performance
relative to using all trades, or the last quote of the day. Therefore, we remove observations
where the par value of the transaction is less than or equal to $100. 000 ( Edwards, Lawrence,
and Piwowar (2007)) as they tend to be non-institutional trades. The prices reported in the
TRACE database are the clean prices. They do not include the accrued coupon payment.
We add the accrued coupon payment to the clean prices by merging in variables from the Mer-
gent FISD database. The nal bond prices that we use are therefore the settlement prices.
Finally, following Bessembinder, Kahle, Maxwell, and Xu (2009), we calculate the daily bond
price using the trade-weighted average of all the prices reported during that day.
Similar to our analyses for stock returns, we consider a rating change event on a debts
issuer as one observation. In a number of cases, there are multiple bond issues per issuer.
19
These multiple issues usually experience rating changes on the same day. In order to avoid
double counting rating change events, we study the return of a weighted bond portfolio (equal
or value weighted) for each rm. We construct both the equal- and value-weighted portfolios
using all the issues written on a rm. We nd that the results are not qualitatively aected
by the weighting methods. To save space, we present only the results that are based on the
value-weighted portfolios.
Table 9 displays the number of upgrades and downgrades and the size of rating changes
per year. There are 1.6 downgrades for every upgrade in the bond sample. This value is lower
compared to the stock sample (Table 1) which contains 2.2 downgrades for every upgrade.
Relative to the stock sample, we nd fewer number of rating events between 2002 and 2004.
This is because the TRACE database had limited bond coverage during these early years. It
was not until March 2003 that TRACE begins to cover all the bonds with an issue size of at
least $100 million and rated A or higher. Nevertheless, in the subsequent years, the coverage
has steadily increased to completion. Most of the CDS contracts in our sample start trading
after 2004. For downgrades (upgrades), the mean size of absolute rating change for a rm
without CDS is 1.54 (1.34) and for a rm with CDS is 1.50 (1.24). The Traded-CDS sample
for bonds is constructed in the same manner as for the stocks (see Section 3.2). We observe
a large reduction in the number of observations from the Full sample to the Traded-CDS
sample (about one-fth). Given that we have a small number of observations in the bonds
full sample to begin with, the signicant decrease in observations make the Traded-CDS
sample dicult to work with. The number of unique rms in the Traded-CDS sample is
only 47 (as opposed to 516 unique rms for the full sample). Therefore, we rely mainly on
the Full sample when interpreting the results.
Table 10 reports the distribution of the absolute magnitude of rating changes. It is calcu-
lated by rounding o, to the nearest integer, the value-weighted rating scale changes of the
multiple bond issues written on a rm on the rating event day. Consistent with the stock
sample, rating changes by one notch account for most of the sample ( 70%) for downgrades
20
and upgrades. Overall, the bond sample, although much smaller, is similar to the stock sample
in terms of the distribution of rating changes and the number of downgrades to upgrades.
4.2 Abnormal bond return
We study the changes in abnormal bond returns around the rating change dates. Unlike the
stock sample analysis, bond trading is relatively thin. We therefore face several econometric
diculties concerning the calculation of abnormal bond returns. Based on our ltered sample
for the years 2006 and 2007, we nd that on average, each bond trades in only 30 days
per year. Conditional on the day that we observe trades, the average number of trades is
3.48 times per day.
10
To compute abnormal bond returns, we follow the method advocated
in Bessembinder, Kahle, Maxwell, and Xu (2009) by dierencing the raw returns with the
benchmark of indices. We match returns to six benchmark indices based on the Moodys six
major rating categories (Aaa, Aa, A, Baa, Ba, and B), and the equivalent S&P and Fitch
rating categories corresponding to the rating scale 1 to 16 (See the mapping in Appendix
A). Matching further on additional dimensions yields an inadequately small sample as the
majority of bonds do not trade daily.
We construct daily bond return indices based on the above six rating categories. For each
rating category, we compute the daily index return using all the bonds rated in that category.
Bonds of a rms that are rated on the day the index is constructed are excluded. Because few
bonds trade on a daily basis, the composition of the index change from one day to the next.
As suggested by Bessembinder, Kahle, Maxwell, and Xu (2009), the bond index returns are
computed using value-weighted average to reect the daily change in index composition.
We designate the rating change event day as day 0. The cumulative bond return is rst
computed per issue using the last transaction price observed between event-day -7 to -1 and
the rst transaction price between event-day +1 to +7. On average, we observe transaction
prices on -2.4 and +2.3 event-days relative to the event date. Sampling windows of (-3,+3) and
10
For this analysis, we consider the sample from 2006 onwards when TRACE gained complete coverage of
the corporate bond data.
21
(-5,+5) lead to a very small sample of unique rms for the Traded-CDS sample. Although
we can increase the number of observations by extending sampling window, e.g. (-10,+10),
such procedure increases the bias due to confounding information arrivals.
11
The cumulative abnormal return for the bond is then calculated by subtracting the cu-
mulative bond return with the cumulative bond index return over the same window period.
Finally, the bond market reaction to a rating change event for a rm is calculated as the
value-weighted average returns of all of the issues traded around the event date.
4.3 Univariate results
Table 11 reports the mean CAR for the pre- and post-CDS trading periods.
12
The results in
Panel A are based on the full sample. Consistent with prior literature (Hand, Holthausen,
and Leftwich (1992)), we nd that bond prices react signicantly to downgrades (-0.89%) and
upgrades (0.10%). The nding that bond prices react signicantly to upgrades diers from
our results for the stock market which does not react signicantly to upgrades. We conjecture
that the reaction of the bond market to upgrades is possibly due to the regulatory eect of the
rating agencies. Panel A reports the mean of bond CARs over the event window (-7, +7) on
the rating change date. In both cases, the reactions to downgrades are negative and signicant
a the 1% level. However, the magnitude of bond price reaction is signicantly weaker in the
post-CDS period compared to the pre-CDS period. The mean CARs for the pre- and post-
CDS cases are -1.40% and -0.52%, respectively. Their dierence is signicant at the 1% level.
For upgrades, the dierence between bond price reactions in the pre- and post-CDS cases is
not signicant. This set of results is consistent with the evidence documented in prior studies
- rms tend to hide negative information whereas they voluntarily release good information.
Panel B of Table 11 displays results for the Traded-CDS sample. This sample represents
11
Several rm-specic news releases are often released around the rating change announcements (see Shivaku-
mar, Urcan, Vasvari, and Zhang (2010), and Elkamhi, Jacobs, Langlois, and Ornthanalai (2011)). Therefore,
extending the sampling window further increases the chance that rating change event coincides with other
important news releases.
12
All cumulative abnormal returns are winsorized at the 1% level.
22
rms that have CDS traded at some point during the sample period from 2002 to 2007.
Again, we nd that the overall bond price reaction to downgrades is negative (-0.87%) and
signicant at the 1% percent level. Consistent with our hypothesis, the magnitude of bond
market reaction is weaker in the post-CDS period (-0.71%) compared to the pre-CDS period
(-1.05%), although not signicant. The fall in statistical power is clearly due to the small
sample size. The Traded-CDS sample corresponds to the rating events of only 47 unique
rms whereas the full sample (Panel A) corresponds to the rating events of 516 unique rms.
As a result, tests reported in Panel B are not very powerful.
4.4 Robustness tests for bonds
To rule out concerns that our results are due to outliers, we test for the dierence in the means
of bond price reactions using the bootstrapping method.
13
Conrming the above ndings, the
bootstrapping method indicates that the magnitude of bond price reaction is signicantly
weaker in the post-CDS period compared to the pre-CDS period at the 1% level. The above
results are robust to a series of other robustness checks. The same conclusion is obtained when
we replicate the bond results using various subsamples such as, looking only at senior bonds,
and those without asset backing or without enhancements. We also test for the robustness
of our results to dierent event-window lengths. We nd that the results are qualitatively
similar when the event windows (-3,3), (-5,+5), and (-10,+10) are employed.
A possible concern is that the above results may be related to changes in certain market
conditions over time, such as the changes in volatility of the bond market or the change
in coverage of the TRACE database.
14
We tackle this concern using a placebo test by
applying the event study methodology to randomly generated pre- and post-CDS periods.
We nd that the CARs on these random event periods are not signicantly dierent from
zero. The dierence in bond price reactions between the pre- and post- CDS periods is also
not signicantly dierent from zero, conrming the ecacy of our bonds abnormal return
13
Each bootstrapped estimator is computed using 1000 draws randomly sampled with replacement.
14
Coverage of TRACE database prior to 2004 was limited only to higher rated bonds.
23
computation.
5 Economic channels
In this section, we examine why stock and bond prices react signicantly less to credit rating
downgrades in the presence of CDS contracts. Flannery, Houston, and Partnoy (2010) ar-
gue that CDS spreads are viable substitutes for credit ratings because they incorporate new
information about the underlying rm more quickly than credit ratings.
15
Following Flan-
nery, Houston, and Partnoy (2010), we explore economic channels to which the CDS market
provides informational contents that are either similar or exceeding those captured by credit
rating changes. First, we test whether CDS spreads explain the cross section of primary
and secondary bond yields better than credit ratings. If CDS spreads provide information
about the bond yields that is superior to credit ratings, then rating changes issued by credit
rating agencies should become less relevant to investors. Second, we compute time series of
credit rating scales implicit in CDS spreads (CDS-implied ratings) and examine their dynamic
around rating change events. Finally, we apply duration analysis to test whether trading in-
formation in the CDS market can predict future downgrades by rating agencies. The following
subsections report our ndings.
5.1 Bond yields regression
We run regressions to study the relative importance of CDS spreads to credit ratings in
explaining the primary and secondary market bond yields. To carry out these regression,
we merge CDS quotes with the bond data. The dependent variables are corporate bond
yields observed in the primary bond issuance (Table 12), and in the secondary market trading
(Table 13). Firm-level control variables that we use are quarterly rm fundamentals from
COMPUSTAT. They include interest coverage dummies, log total assets, market value of
15
Flannery, Houston, and Partnoy (2010) study CDS spreads of fteen large nancial institutions in 2006-
2009.
24
assets, operating income to sales, term spread, long-term debt to assets, total debt to market
value.
16
Appendix B provides describes these control variables. We use the last observed
CDS quote prior to the event window in the regressions. For instance, in the primary market
regressions (Table 12), we use the CDS quotes that are traded immediately prior to the bond
issuance. We use lagged CDS quotes in order to avoid the endogeneity concern that bond yields
and CDS spreads are jointly determined. Because Rating scale variable is discrete while CDS
quote is a continuous variable, we facilitate their comparison by using discretized CDS quotes
in the regressions. We discretize CDS quotes by dividing them into 23 buckets of equal spread
width that is calculated by dividing the range of CDS spreads in the entire sample by 23.
This mapping is consistent with the 23 rating categories used for the rating scale variable.
17
Regression model 2 in Tables 12 and 13 show that CDS alone explains 59.7% and 80.2% of the
primary and secondary market bond yields, respectively. This translates to 13.6% (primary
market) and 35.1% (secondary market) increase in explanatory power compared to regression
model 1 when the rating scale alone is used. The magnitude of the coecient of rating scale
drops to about one-third when the discretized lagged CDS quote and the rm fundamentals are
included. On the other hand, the magnitude of the coecient on discretized lagged CDS quote
decreases only marginally. The results in Tables 12 and 13 demonstrate that CDS spreads
provide value-relevant information in determining bond yields beyond those implicit in credit
ratings. Therefore, when determining bond yields, we nd evidence supporting Flannery,
Houston, and Partnoy (2010) that CDS spreads are a viable and perhaps superior alternative
to credit ratings.
16
In the secondary market yields regression, we follow Campbell and Taksler (2003) and use dummy variables
for dierent interest coverage levels. We generate dummy variables for the following groups of interest coverage:
Interest coverage< 5, 5 _Interest coverage< 10, 10 _Interest coverage< 20, and 20 _Interest coverage.
17
We also carry out the primary and secondary bond yields regressions with the continuous CDS quote
instead of the discretized CDS quote and obtain very similar results.
25
5.2 CDS-Implied ratings
One reason why CDS spreads appear more value-relevant than credit ratings is their timely
response to changes in the underlying rms credit condition. Acharya and Johnson (2007)
nd that information discovery occurs in the CDS market prior to negative credit news. In
this subsection, we back out the rating levels implicit in CDS spreads (CDS-implied ratings)
and compare them to those issued by rating agencies. Our objective is to examine the dy-
namic of CDS-implied ratings around the rating downgrades. If trading in the CDS market
reveals information about changes in a rms default risk, we expect CDS-implied ratings to
signicantly increase prior to a downgrade issued by credit rating agencies.
We calculate CDS-implied ratings following the approach in Breger, Goldberg, and Cheyette
(2003) and Kou and Varotto (2008). The basic idea is to estimate the CDS boundaries sep-
arating two adjacent rating groups in a nonparametric manner. Once the boundaries are
determined, we assign each rm into a rating class corresponding to its CDS spread level.
We estimate CDS boundaries by minimizing the penalty function with the objective of re-
ducing the number of misclassications. We dene missclassication as the discrepancy in
the rms CDS spread level and its rating class. For instance, missclassication occurs when
CDS spreads of a higher rated rm is larger than the spread of a lower rated rm. Following
this intuition, the penalty function for estimating the boundary between AA and A ratings
classes, /
AAA
. is
1(/
AAA
) =
1
:
m
X
i=1
[max(:
i;AA
/
AAA
. 0)]
2
+
1
:
n
X
j=1
[max(/
AAA
:
j;A
. 0)]
2
. (3)
where :
i;AA
is the CDS spread of AA-rated rm i, and :
j;A
is the CDS spread of A-rated rm
,. The number of rms in the AA and A rating classes are denoted : and :, respectively. The
penalty function for estimating boundaries between other adjacent rating classes are dened
similarly.
18
We estimate CDS spread boundaries for all adjacent one-letter rating classes from
18
Fitch estimates CDS-implied ratings based on a method similar to ours with a slightly dierent penalty
function. As a robustness check, we implement Fitchs penalty function and obtain the same boundaries.
26
AA to CCC rating classes.
19
The estimation uses all CDS spreads on rms that have been
recently re-rated (within 15 days) in order to ensure that the boundaries are mapped to the
most current rating scale.
Figure 1 plots average CDS-implied ratings over the interval [-360,180] days centered on the
rating change events. The solid line plots the ocial ratings issued by credit agencies while the
dotted line plots average CDS-implied ratings. To save space, we plot results for two adjacent
rating classes that have the most number of rating change events: BBB-BB, and BB-B.
The top two panels plot average implied-CDS ratings around downgrades from BBB and BB
classes, while the bottom two panels plot average implied-CDS ratings around upgrades from
BB and B classes. Figure 1 shows that CDS-implied ratings started increasing at least 180 days
prior to a downgrade announcement. This nding suggests that the CDS market responds
to the rms deteriorating credit quality signicantly faster than credit rating agencies. On
the other hand, Figure 1 shows that CDS-implied ratings do not change signicantly prior to
an upgrade announcement, consistent with the observations that rating upgrades have little
pricing relevance.
5.3 Do CDS spreads signal future downgrade?
Consistent with the market eciency hypothesis, if CDS spread changes signal future down-
grades, then stock and bond prices should react signicantly less on the rating announcement
date because such news is anticipated. We test the hypothesis that information derived from
the CDS market can predict future downgrades using the hazard model.
20
Hazard function
plays a key role in duration analysis. Let 1 _ 0 denotes the time of rating change announce-
ment, and t denotes the current time period. The conditional probability that the rm will
be downgraded/upgraded between time t and t + , P(t _ 1 < t + [1 _ t), is related to the
19
Due to the large number of observations required to precisely estimate each boundary, we do not consider
rating changes within the same one-letter rating class. For instance AA+, AA, AA- are considered to be rated
AA.
20
Using a logistic model, Hull, Predescu, and White (2004) show that changes in CDS spreads increase the
likelihood of future rating events.
27
following hazard rate function:
/(t) = lim
y!0
P(t _ 1 < t + [1 _ t)

. (4)
In the Cox proportional hazard (PH) model, the hazard function is usually represented by
/(t. X) = /
0
(t)c
P
n
i=1

i
X
i
.
where X is a time-independent vector of explanatory variables for the hazard rate /(t. X),
and /
0
(t) is the baseline hazard function. The advantage of the Cox PH model is that the
baseline hazard function is semi-parametric. That is, we do not need to specify the functional
form of /
0
(t). In case of the Cox PH model, only the estimates of ,
0
: are required to assess
the eects of the explanatory variables X on the hazard rate. Moreover, Cox PH model is
preferred over a logistic model because it is well suited for handling censored data which is a
central issue in duration studies (see Efron (1977)). Consequently, analysis using the Cox PH
model uses signicantly more information than a simple logistic model.
For our analysis, we use theStratied Cox model (SC model) which is an adaptation
of the Cox PH model. The SC model uses stratication to control for a predictor that does
not satisfy the PH assumption. More specically, stratication allows the baseline hazard
function /
0
(t) to be dierent for dierent strata while sharing the same coecients ,
0
:. Table
14 reports the results from estimating the SC model separately for downgrades (Panel A) and
upgrades (Panel B) using bonds rating scale as the strata.
21
The survival time at time t
in our analysis is the number of quarters from now to the next rating change event. Thus,
it is denoted by 1 t. The control variables are one-quarter-lagged rm fundamentals that
we used in the secondary market bond yields regression (Section 5.1). Appendix B provides
denitions of these rm-level variables. The variables of interest in Table 14 are Lagged spread
21
We conrm the importance of using SC model with rating scale as the strata by testing whether the
proportional hazard (PH) assumption holds. Following the test of Grambsch and Therneau (1994), we reject
the PH assumption when using rating scale as a predictor for downgrades at the 5% level.
28
change, Lagged log number of quotes, and Lagged abs spread change. These three variables,
respectively, capture the previous quarters spread change, trading activity, and volatility level
in the CDS market. Lagged spread change is the change in CDS spreads over the previous
quarter, i.e. end-of-the-quarter spread minus start-of-the-quarter spread. Lagged log number
of quotes is the log of cumulative number of quotes observed in the previous quarter. Finally,
Lagged abs spread change is the sum of absolute daily CDS spread changes in the previous
quarter (over 90 days). We include year xed eects in all the regressions.
Specications 1-3 in Panel A of Table 14 show that the likelihood that a rm is downgraded
in the next quarter is related to the change, trading activity, and volatility level in the current
CDS market. The coecient of Lagged spread change is positive and signicant at the one
percent level. This nding is consistent with our hypothesis that CDS spreads provide a more
timely update of the rms deteriorating credit condition than credit rating agencies. The
coecients of Lagged log number of quotes, and Lagged abs spread change are also positive
and highly signicant. Trading activity, and volatility level in the CDS market therefore
increases signicantly prior to a downgrade. Jarrow (2011) argues that CDS contracts help
market completion by allowing investors to better hedge their credit risk. Our nding that
the trading activity and volatility level increases prior to a downgrade show that investors
use CDS contracts to hedge their credit risk position. Consistent with Jarrow (2011), stock
and bond reactions to credit rating downgrade should signicantly decrease in the presence of
CDS because investors can immunize their credit risk exposure by trading in CDS contracts.
Specications 4-7 in Panel A report results from alternative regression models. Overall, we
nd that the predictive power of Lagged spread change and Lagged log number of quotes are
very robust. On the other hand, the coecient of Lagged abs spread change is positive but
not signicant when we use all three proxies for CDS information.
Panel B of Table 14 report the results for upgrades. The coecients of Lagged spread
change in all specications are negative consistent with the intuition that the rms credit
risk condition improves prior to an upgrade. However, none of the coecients in Panel B
29
are statistically signicant conrming our previous ndings that upgrades are generally not
informative.
6 Conclusion
We present evidence that the informativeness of credit rating downgrades decreases when the
underlying rm has CDS trading on its debt. The abnormal stock return around the credit
rating downgrade is signicantly weaker for rms with traded CDS compared to rms without
traded CDS. Restricting attention to rms that have CDS traded, we show that once CDS
starts trading on the rms debt, the stock market reaction to credit rating downgrades is
much weaker as compared to the period when CDS was not trading on the rms debt. Our
results are robust to dierent model specications and a propensity score based matching
analysis. We also show that bond markets react less to credit rating downgrades in the
presence of CDS. Lastly, we examine various economic channels that can potentially explain
our result. We show that CDS spreads explain the cross-sectional variation in primary and
secondary market bond yields better than credit ratings. We also back out the rating levels
implicit in CDS spreads and nd that CDS-implied ratings signicantly lead rating changes
issued by credit rating agencies by more than 180 days. Overall, the evidences indicate that
both equity and bond markets place less reliance on credit rating announcements when CDS
contract is traded on the underlying rms debt. An important implication of the evidence
presented in the paper is that, stock and bond markets perceive CDS as a viable alternative
to credit ratings. It may be more benecial for regulators to design policies that can enhance
the transparency and liquidity in the CDS market instead of solely focusing on regulating the
credit rating agencies.
30
Appendix A Classication by rating agencies
The table presents the mapping of rating codes issued by S&P, Fitch, and Moodys to the cardinal scale
used in our analysis. The rating codes used by S&P and Fitch are similar but are dierent from those
used by Moodys. Moodys uses code from Aaa down to C to rate bonds whereas S&P and Fitch rate
bonds from AAA down to D. Within the 6 classes from AA to CCC for S&P and Fitch, the rating agen-
cies have three additional gradations with modiers (+,none,-). For examples, S&Ps AA rating class
is subdivided into AA+, AA, AA-. Similarly, Moodys has three additional gradations with modiers
1,2,3 from Aaa to Caa. We transformed the credit ratings of the three rating agencies into a cardi-
nal scale starting with 1 as AAA(Aaa), 2 as AA+(Aa1), 3 as AA(Aa2), and so on until 23 as the de-
fault category. Fitch provides three ratings for default. We follow Jorion, Liu, and Shi (2005) by using
23 instead of 22 as the cardinal scale for Fitchs default category which corresponds to the DD rating.
Explanation Standard & poors Moodys Fitch Cardinal Scale
(modiers) (modiers) (modiers)
Investment grade
Highest grade AAA Aaa AAA 1
High grade AA (+,none,-) Aa (1,2,3) AA (+,none,-) 2,3,4
Upper medium grade A (+,none,-) A (1,2,3) A (+,none,-) 5,6,7
Medium grade BBB (+,none,-) Baa (1,2,3) BBB (+,none,-) 8,9,10
Speculative grade
Lower medium grade BB (+,none,-) Ba (1,2,3) BB (+,none,-) 11,12,13
Speculative B (+,none,-) B (1,2,3) B (+,none,-) 14,15,16
Poor standing CCC (+,none,-) Caa (1,2,3) CCC (+,none,-) 17,18,19
Highly speculative CC Ca CC 20
Lowest quality C C C 21
In default D DDD/DD/D 23
31
Appendix B Bond yields regression variables
Bond return = raw bond return around the rating change event (t = 0) calculated as:
1o:d1ctn::
t=0
=
1o:d1:icc
t+7
1o:d1:icc
t7
+ cc:ncd1:tc:c:t
1o:d1:icc
t7
Daily bond index = value-weighted bond index returns partitioned by rating based on
Moodys six major rating categories
Total debt = long-term debt + short-term debt
Market value of assets = (stock price shares outstanding) + short-term debt + long-
term debt + preferred stock liquidation value deferred taxes and investment tax
credits
Term spread = yield spread between the 10- and 1-year treasury bonds
Operating income to sales = operating income after depreciation sales
Total debt to market value = total debt (market value of equity + book value of total
liabilities)
Long-term debt to total assets = long-term debt book value of total assets
Interest coverage = (operating income after depreciation + interest and related expense)
interest and related expense
32
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34
Figure 1. CDS-implied credit ratings
-300 -200 -100 0 100
2.5
3
3.5
4
4.5
Downgrade from BBB
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4
Event day
Upgrade from B
Rating agencies CDS-implied ratings
We plot average CDS-implied ratings over the interval [-360,180] days centered on the rating
change events. We plot the results for downgrades (top panels) and upgrades (bottom panels)
for two adjacent rating classes that have the most number of rating change events: BBB-BB,
and BB-B. CDS-implied ratings are computed following the nonparametric method in Breger,
Goldberg, and Cheyette (2003) and Kou and Varotto (2008). The solid line plots the ocial
ratings issued by credit agencies while the dotted line plots average CDS-implied ratings.
35
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37
Table 3: Stock price (CAR) response to bond downgrades and upgrades
The sample consists of 4195 downgrades and 1856 upgrades of taxable corporate bonds issued by U.S.
rms from January 1998 to December 2007. The sample is split between rating changes that occur in
the presence of CDS trading (post-CDS period), and in the absence of CDS trading (pre-CDS period)
on the underlying rms debts. CAR is the cumulative abnormal return dened as the abnormal return
(computed using the market model) cumulated over the 3-day event window (-1,+1), where day 0 rep-
resents the rating change event day. Panel A displays results for the full sample consisting of two rm
types: rms that have CDS traded (traded-CDS rms), and rms that never have CDS traded (non-
traded-CDS rms) during 1998-2007. Panel B displays results for the "Year 01-07" sample which ex-
cludes the period prior to the implementation of the Fair Disclosure (FD) regulation. T-statistics are dis-
played in square brackets. *, ** and *** indicate signicance greater than 10%, 5% and 1%, respectively.
Downgrades Upgrades
Full Sample Mean % Count Mean % Count
CAR CAR
Panel A: Distribution of CAR for full sample from 1998 to 2007
Pre-CDS -4.61*** 3382 0.09 1383
[-9.58] [0.68]
Post-CDS -1.22*** 813 -0.01 473
[-3.99] [-0.04]
Dierence -3.39*** 0.09
(PrePost) [-3.42] [0.39]
Total -3.95*** 4195 0.06 1856
[-10.06] [0.61]
Downgrades Upgrades
Year 01-07 Mean % Count Mean % Count
CAR CAR
Panel B: Distribution of CAR for all rms from 2001 to 2007
Pre-CDS -4.63*** 2234 0.09 905
[-6.79] [0.61]
Post-CDS -1.22*** 813 -0.01 473
[-3.99] [-0.04]
Dierence -3.41*** 0.10
(PrePost) [-2.98] [0.41]
Total -3.72*** 3047 0.06 1378
[-7.34] [0.51]
38
Table 4: Stock price (CAR) response to bond downgrades and upgrades: traded-
CDS rms
The sample consists of 1249 downgrades and 610 upgrades of taxable corporate bonds issued by U.S. rms
from January 1998 to December 2007. This sample consists only of rms that have CDS trading at some
point between 1998 to 2007. The sample is split between rating changes that occur in the presence of CDS
trading (post-CDS period), and in the absence of CDS trading (pre-CDS period) on the underlying rms
debts. CAR is the cumulative abnormal return dened as the abnormal return (computed using the mar-
ket model) cumulated over the 3-day event window (-1,+1), where day 0 represents the rating change event
day. Panel A displays results for the Traded-CDS sample consists of only traded-CDS rms from Janu-
ary 1998 to December 2007. Traded-CDS Balanced represents a sample of only traded-CDS rms for the
balanced time panel of 3 years before and 3 years after the CDS introduction dates. T-statistics are dis-
played in square brackets. *, ** and *** indicate signicance greater than 10%, 5% and 1%, respectively.
Downgrades Upgrades
Traded-CDS Mean % Count Mean % Count
CAR CAR
Panel A: Distribution of CAR for all traded-CDS sample from 1998 to 2007
Pre-CDS -2.92*** 714 0.53* 264
[-5.61] [1.80]
Post-CDS -0.71*** 615 -0.06 394
[-2.82] [-0.34]
Dierence -2.21*** 0.60*
(PrePost) [-3.64] [1.80]
Total -1.90*** 1329 0.18 658
[-6.24] [1.09]
Downgrades Upgrades
Traded-CDS Balanced Mean % Count Mean % Count
CAR CAR
Panel B: Distribution of CAR for all traded-CDS rms for balanced sample
Pre-CDS -2.52*** 531 0.52 149
[-4.22] [1.38]
Post-CDS -0.72** 475 -0.05 289
[-2.33] [-0.19]
Dierence -1.80*** 0.57
(PrePost) [-2.60] [1.32]
Total -1.60*** 1029 0.13 503
[-4.96] [0.75]
39
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43
Table 8: Regression results for the matched sample of stock price response (CAR)
to bond downgrades and upgrades
The sample consists of 1650 downgrades and 886 upgrades of taxable corporate bonds issued by U.S. rms
from January 1998 to December 2007. We further split the sample into the treated group and the control
group. The treated group consists of all rms for which CDS trades at some point in our sample period
(traded-CDS rms). The control group consists of rms for which CDS never trades throughout our sample
period (non-traded-CDS rms). The rms in the control group are matched to similar treated-group rms
based on the propensity score matching and are assigned counterfactual start dates for CDS trading. The
dependent variable CAR is the cumulative abnormal return dened as the abnormal return (computed using
the market model) cumulated over the 3-day event window (-1,+1), where day 0 represents the rating change
event day. "Full" sample represents the entire sample period matched rms. "Balanced" is a balanced time
panel of the matched pairs of rms 3 years before and 3 years after CDS starts trading. dIgrade is a dummy
variable equal to one if a bond is revised from investment grade to speculative grade or vice-versa and zero
otherwise. dCDS is a dummy variable equal to one if the rating change takes place when CDS trades for the
underlying and is zero otherwise. ScaleDiff is the absolute value of rating change cardinal value. LnDays
is the natural logarithm of the number of days between the previous rating change in the same direction for
the same bond but by another rating agency. dControl is a dummy variable that takes the value 1 for a rm
in the control group which is matched with a traded-CDS rm and value zero otherwise, dCDSxdControl
is an interaction term between the dummy variables dCDS and dControl. Firm controls include, Leverage
dened as the total debt over assets; ProfMargin dened as net income over sales; LnMktV al as the natural
logarithm of the market value of the entity. All standard errors are clustered at rm level. T-statistics are
displayed in square brackets. *, ** and *** indicate signicance greater than 10%, 5% and 1%, respectively.
44
Table 8: (Table 8 Cont.) Regression results for the matched sample of stock price
response (CAR) to bond downgrades and upgrades
Downgrades Upgrades
Full Balanced Full Balanced
dCDS 2.05*** 1.86** -0.08 0.28
[2.69] [2.21] [-0.19] [0.49]
dControl -0.18 -0.85 -0.14 0.75
[-0.18] [-0.71] [-0.26] [1.04]
dCDSdControl -3.36** -3.44** 0.13 -0.71
[-2.34] [-2.13] [0.17] [-0.76]
dIgrade -2.78*** -4.12*** 1.14** 0.72
[-3.01] [-4.09] [1.97] [1.02]
ScaleDi -0.69* -0.37 0.22 0.15
[-1.88] [-0.87] [0.96] [0.61]
LnDays 0.20 0.19 0.22 0.26
[0.66] [0.58] [1.09] [1.02]
Leverage -0.75 -5.48** -0.69 -0.78
[-0.33] [-2.15] [-0.74] [-0.69]
LnMktVal -1.15*** -1.63*** -0.15 -0.06
[-3.71] [-4.77] [-0.86] [-0.27]
ProfMargin 2.51 1.82 1.87 -0.02
[1.04] [0.67] [1.36] [-0.01]
Constant 8.19** 13.73*** 0.72 -0.47
[2.58] [3.86] [0.39] [-0.21]
` 925 724 501 335
adj. 1
2
0.029 0.055 -0.001 -0.015
45
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47
Table 11: Bond price (CAR) response to downgrades and upgrades
The sample consists of 1029 downgrades and 650 upgrades of taxable corporate bonds issued by U.S.
rms from July 2002 to December 2007. The sample is split between rating changes that occur in
the presence of CDS trading (post-CDS period), and in the absence of CDS trading (pre-CDS period)
on the underlying rms debts. CAR is the cumulative abnormal return dened as the rms value-
weighted bond portfolios excess return against the bond return of a matching portfolio based on Moodys
six major rating categories (Aaa, Aa, A, Baa, Ba, and B). The event window is the shortest trading
window within (-7,+7), where day 0 represents the rating change event day. Panel A displays results
for the Full sample consisting of traded-CDS rms non-traded-CDS rms. Panel B reports the re-
sults for the Traded-CDS sample which consists only of traded-CDS rms. T-statistics are displayed
in square brackets. *, ** and *** indicate signicance greater than 10%, 5% and 1%, respectively.
Downgrades Upgrades
Full Sample Mean % Count Mean % Count
CAR CAR
Panel A: Distribution of bond CAR for the full sample
Pre-CDS -1.40*** 430 0.12** 280
[-7.05] [2.14]
Post-CDS -0.52*** 599 0.08* 370
[-7.85] [1.67]
Dierence -0.88*** 0.04
(PrePost) [-4.76] [0.55]
Total -0.89*** 1029 0.10*** 650
[-9.59] [2.67]
Downgrades Upgrades
Traded-CDS Mean % Count Mean % Count
CAR CAR
Panel B: Distribution of bond CAR for traded-CDS rms
Pre-CDS -1.05** 80 0.01 52
[-2.51] [0.12]
Post-CDS -0.71*** 87 0.20* 73
[-2.83] [1.94]
Dierence -0.34 -0.19
(PrePost) [-0.72] [-1.14]
Total -0.87*** 167 0.12 125
[-3.65] [1.53]
48
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