Are credit rating agencies discredited? Measuring market price effects from agency sovereign debt announcements

Summary

Focus

This paper looks at whether the information value of credit rating agency announcements relating to sovereign bonds has diminished since the Global Financial Crisis (GFC) of 2007-09. In particular, taking into account the prior credit status of the bonds, we measure how the response of credit default swap spreads (CDS) to such announcements has changed.

Contribution

Rating agencies were sharply criticised for their credit risk assessments of certain derivative products in the run-up to the GFC and subsequently when certain European sovereign bonds were downgraded. This may have led investors to discount the information value of their assessments. We look at whether the response of CDS spreads to credit rating announcements - including rating changes, watch status and outlook status - have changed since the GFC.

Previous studies investigating the informational value of rating agencies' assessments have often obtained contradictory results. We show that this is partly attributable to a failure to adequately capture transitional states. In our measurement of the marginal informational value of agency announcements, we carefully control for the specific transition from one state, as designated by an agency, to another. For example, an announcement may signal a downgrade. But whether this transition is from a "stable", "negative watch" or "negative outlook" designation matters. Similar distinctions are also important for "watch" and "outlook" announcements.

Findings

Overall, we find that upgrades and downgrades from a stable/developing status exhibit the strongest market responses. By contrast, the responses are weakest when the bonds are already under watch. Following the GFC, announcements continued to have statistically significant impacts on CDS spreads, although such impacts were substantially less pronounced for most announcement categories. Weaker responses were especially noteworthy for credit downgrades transitioning from negative outlook states, and for negative outlook announcements transitioning from stable states.

Abstract

This paper investigates whether the price response to credit rating agency (CRA) announcements on sovereign bonds has diminished since the Global Financial Crisis (GFC). We characterize credit rating events more precisely than previous work, controlling agency announcements for the prior credit state - outlook, watch/review, or stable status as well as the level of the credit rating. Emphasizing the transition from one state to another allows us to distinguish between different types of announcement (rating changes, watch and outlook events) and their price effects. We employ an event study methodology and gauge market response by standardized cumulative abnormal returns (SCAR) and directional change statistics in daily credit default swap (CDS) spreads. We find that rating announcements provide a rich and varied set of information on how credit rating agencies in fluence market perceptions of sovereign default risk. CRA announcements continued to have significant effects on CDS spreads after the GFC, but the magnitude of the responses generally fell. Moreover, we find that accurate measurement of these effects depends on conditioning for the prior credit state of the sovereign bond.

JEL classification: F30, G01, G24, H63

Keywords: CDS spreads, credit ratings, sovereign debt