MGT-435B Bond Markets – Final Project Report:

The Economic Function of Credit Rating Agencies - What does the Watchlist tell us? Christina E. Bannier, Christian W. Hirsch (2010)

Executive Summary
In the “Economic Function of Credit Rating Agencies” by Christina Bannier and Christian Hirsch (2010), the authors researched whether the economic role of credit rating agencies have been enhanced after the introduction of Watchlists. Therefore, the focus of this paper is to analyze the shift in function of credit rating agencies from a passive player providing creditworthiness certification to a more active credit monitoring entity.
First, the paper examines if the Watchlist instrument changes the informational content of credit ratings. Next, the paper tested between two different explanatory lines regarding the function of the rating agencies by analyzing their use of the Watchlist as delivering information to market participants and creating an implicit contract to influence a firm’s risk choices via the threat of a credit downgrade.
They find that the general market reaction to downgrades is stronger in the post-Watchlist period, which is consistent with previous research conclusions. These results hence indicate that the informational content of rating downgrades has strongly risen after the introduction of Watchlist. Additionally, the authors find that direct rating downgrades trigger a much stronger market reaction than watch-preceded downgrades.
These findings support previous conclusions by Cheng and Neamtiu on whether and how rating agencies respond to mounting regulatory pressure. With the introduction of the Watchlist, rating agencies provide timely and accurate information to market participants. The Watchlist instrument has enhanced the role of credit rating agencies. As a result, markets have placed more confidence in the conclusive results of the review procedure as it is seen as another level of information to financial markets.

Credit Rating Agencies
The purpose of credit rating agencies is to offer investors valuable information about the creditworthiness of countries, business entities, and securities. Credit rating agencies have appeared from investor’s need for quality and objective company information to accurately measure the creditworthiness of the issuer. Another important function was to provide a standard comparison and rating scale that investors and creditors could use to make informed investment decisions. Credit agencies do not provide investment advisory services in terms of recommendations for sale or purchase of securities; they provide an opinion on the default probability of the debt issuer or securities. Evaluation and opinion are based on analysis of experienced professionals who evaluate and interpret public and non-public information.
The apparent result of the functions of credit rating agencies has a greater effect on the financial state of the economy. If rating assessments are a good indication of default risk, then one can assume that investors can correctly incorporate risk into asset prices ex-ante. The effects of such investments would mean that companies make appropriate returns that allow them to remain profitable, increase employments, and contribute to the wealth of the economy.
In recent years, credit rating agencies have found themselves targeted by many critics, mainly because they were an underlying factor of the global financial crisis by improperly rating risky investments. Also, they were criticized for merely reacting to firm events rather than being more proactive and providing additional information to the markets. To address this issue, rating agencies developed a short-term credit outlook review process referred to as the “Watchlist.”
What is a Watchlist?
In the mid-1980s, credit rating agencies began to publish a schedule of all company credit ratings currently under review and labeled it the Watchlist. From the early 1990s, the Watchlist was considered a formal rating action due to the increased use of credit ratings in bond and equity markets as a signal for investment quality.
A Watchlist, also known as rating watch, rating review, or credit watch, indicates to the market that a company’s credit rating may change in the near future. It represents a credit rating agency's opinion on the development of a company’s ability to repay its debts over the next three months. Being added to a Watchlist is generally precipitated by a major corporate event such as the announcement of an acquisition, trends in the company’s financial statements, or private information supplied only to credit rating agencies.
During the review, the credit rating agency usually interacts with the target company and collects additional information to support the analysis. The Watchlist is eventually resolved by the announcement of a rating upgrade, downgrade, or a rating confirmation. The results of a Watchlist are intended to be more proactive than traditional credit outlooks to provide equity and bond markets new information regarding the on-going potential default probability of a firm.
Previous Research Findings
There is an established body of knowledge that has confirmed that market asset prices react differently to Watchlist downgrades versus Watchlist upgrades. According to John Hand et al. in “The Effect of Bond Rating Agency Announcements on Bond and Stock Prices” (1992), downgrades are generally followed by a reduction of 0.5% to ~4% in bond and equity prices, whereas upgrades are generally followed by insignificant increases. The significant reduction in asset returns following a Watchlist downgrade implies that additional information is supplied to capital markets than what was publicly available prior to the downgrade. This reaction may be a result of firms being more inclined to withhold negative news or only share it with credit rating agencies and the resultant downgrade exposes the impacts of this additional info. It could also be a result of the tendency for downgrades to be associated with more than one notch change in rating class (e.g., AA+ to BBB), whereas 81% of upgrades are increased by only one notch (Jorion and Zhang, “Information Effects of Bond Rating Changes,” 2007).
Where previous research findings differ is in the significance of rating upgrades resulting in abnormal increases in asset prices. According to “Information Effects of Bond Rating Changes: The Role of the Rating Prior to the Announcement,” by Jorion and Zhang (2007), Watchlist upgrades result in statistically significant increased returns for speculative grade firms. The significance of a rating upgrade disappears when the firm is already of investment grade or above. Although rating upgrades have been shown to yield increased returns, they are still a factor of 14 times smaller than an equivalent downgrade.
This discovery by Jorion and Zhang highlights the importance of accounting for the firm’s credit rating prior to the change as being the single most important factor in determining the relative impact of the change. “For instance, a downgrade from AA- to A+ involves an increase in default frequency of only 0.4%. This is not likely to have much of an impact on the stock price. In contrast, a downgrade from BB- to B+ involves an increase in default frequency of 5.0%, a much higher number that is more likely to be reflected by a big move in the stock price.” This relationship is highlighted in Figure 1 below.

Figure 1 – Significance of Credit Rating Changes Across Asset Classes
Regulation Fair Disclosure
Regulation Fair Disclosure, which was implemented on October 23, 2000, prohibits U.S. public companies from making selective, non-public disclosures to favored investment professionals. However, the regulation made an exclusion allowing firms to disclose non-public information to credit rating agencies. Jorion et al. (2004) found that Regulation FD enabled rating agencies to have access to confidential information making agencies the main conduits of selective disclosure to public. Hence, Regulation FD conferred a strategic informational advantage to rating agencies pronouncing the effect of ratings changes on stock prices. Hence, Bannier and Hirsch controlled for the introduction of Regulation FD by including a dummy variable in their analysis. However, the variable had no explanatory power in the regression model the authors used for this research.
Primary Research
The paper of interest is the “Economic Function of Credit Rating Agencies” by Christina Bannier and Christian Hirsch (2010). The authors attempted to research whether the economic role of credit rating agencies have been enhanced after the introduction of Watchlists. Therefore, the focus of this paper is to analyze the shift in function of credit rating agencies from a passive player providing creditworthiness certification to a more active credit monitoring entity.
Why would this particular market be a good place to test their hypotheses?
The authors chose an appropriate market to test the hypothesis of the significance of the Watchlist because financial markets provide relevant information on the behavior and reaction of market participants to changes in firm credit ratings. In addition, Moody’s has been in the business for rating firms and have experience regarding the reaction of market participants’ pre and post the Watchlist era. Using historic figures from Moody’s estimated senior unsecured ratings of US issuers provides adequate data for analysis and a good platform to test the hypothesis. The market has data covering the pre-Watchlist era and also the post-Watchlist period, which can be segregated to exclude rating modifiers. The market also provides information on how firm value changes following direct versus Watchlist preceded rating changes, hence providing valuable information to test the market reaction in different scenarios.
Pre-Study
First, the paper examines if the Watchlist instrument has changed the informational content of credit ratings using the following hypothesis:
The effect of rating changes on the market value of firm equity is stronger in the post-Watchlist era, as compared to the era before the introduction of the Watchlist procedure.
The authors use a univariate test to analyze the effects of rating changes on cumulative abnormal stock returns, differentiating between market reactions before and after the introduction of the Watchlist procedure.
Pre-Study Findings
They find that the general market reaction to downgrades is stronger in the post-Watchlist period, which is consistent with previous research conclusions. In contrast to Jorion’s and Zhang’s analysis, Bannier and Hirsch found no significant market reaction for upgrades; however, it is unclear if they accounted for the firm’s credit rating prior to the Watchlist announcement as espoused by Jorion. These results hence indicate that the informational content of rating downgrades has strongly risen after the introduction of Watchlist validating the pre-study hypothesis. For robustness, the authors considered the effect of factors such as time trends, sample composition effects, business cycle, and fair disclosure regulation. They found that time, sample composition, and size-effects partially explain the higher strength of the market reaction. However, there is still an unexplained part that they attribute to the enhanced informational value of the observed rating action corroborating the hypothesis.
Main Analysis
Next, the paper tested between two different explanatory lines of the function of the rating agencies and their use of the Watchlist: 1. Delivering information: A simple means to comply with investors’ demand for accurate and timely, but stable rating information 2. Implicit Contracting: A tool to monitor firms and influence firms’ risk choices via rating downgrades and subsequent investor reactions
The two lines of argument—delivering information and implicit-contracting—are tested against three attributes: 1) Decision to place a borrower under review, 2) Duration of the Watchlist placement and 3) Market reaction to direct vs. Watchlist-preceded rating changes. The analysis splits the sample into low-quality non-investment grade borrowers (NIG) and high-quality investment-grade borrowers (IG) as well as event-driven Watchlist placement and non-event driven review.
Main Analysis Findings
Review Placement: The results indicate that the size of the company and the stock-price volatility have an equally significant effect on the Watchlist placement for both NIG and IG issuers. Furthermore, for non-event-driven placements it is observed that a NIG firm is more likely to be placed under review the lower its interest payments, the higher its leverage, its market-to-book value and its stock price volatility. Alternatively, the placement of IG firm is influenced by high leverage and stock-price volatility and large company size. However, for event-driven placements the results were not clear. Even still, the analysis reveals that the leverage has a negative influence for NIG issuers, while for IG issuers both the level of fixed assets and proximity to non-investment grade rating have negative effects. These results hint that rating agencies use the review procedure as an instrument to deliver precise and accurate information for high quality borrowers.
Watchlist Duration: With reference to Watchlist duration, the authors observe that the size of the company has significant influence on non-event driven watch listings. The larger the company, the higher the likelihood that the Watchlist is resolved sooner because management is more engaged in assisting the credit rating agency and the size of the company is a proxy for the quality of the management. Moreover, cash holdings increase the likelihood of review termination for event-driven Watchlist placements. Interestingly, the authors also find that non-event-driven Watchlists tend to be more quickly terminated the higher the rated company’s leverage, with a stronger effect for NIG borrowers. A higher leverage increases the incentives of low-quality borrowers to exert sufficient recovery effort to avoid a rating downgrade confirming the implicit-contracting notion.
Market Reaction: Finally, testing market reaction to direct vs. watch-preceded rating changes, the authors find that direct rating downgrades trigger a much stronger market reaction than watch-preceded downgrades. The results remain the same when differentiating between event-driven and non-event-driven watch listings. Also, the market reaction to direct downgrades is much stronger in the post-Watchlist era than in the pre-Watchlist period supporting the notion that the introduction of the Watchlist instrument has affected the agencies’ information provision. Additionally, for borrowers of lower creditworthiness, the Watchlist has enabled the rating agencies to take on an active monitoring role indicating that watch-preceded rating changes are more informative than direct rating changes.
Conclusions
The authors conclude that the introduction of the Watchlist has had an impact on financial markets. The research confirms that market reaction is much stronger to ratings downgrade in the post-watchlist era than in the pre-watchlist period supporting that argument that watchlists have indeed change the informational content of credit ratings. Furthermore, they found that market reaction to direct rating downgrades in the post-Watchlist period were stronger than watch preceded downgrades. This novel result lends support to the hypothesis that the review procedure seems to have enhanced the agencies traditional role as information providers. This result suggest that the credit rating agencies enter into an implicit contract with the firms they rate, particularly with low quality borrowers, as suggested by ‘Boot et al’. The analysis highlights that a direct downgrade signals a firm’s lack of capability to uphold a specific credit quality whereas a watch-preceded downgrade signals a failure in the attempt. Hence, these results also confirm the initial arguments by Moody’s that rating changes for firms placed on Watchlist before rating changes are different from those not preceded by the Watchlist review.
To summarize, Watchlist acts as an active monitoring device that gives the rating agencies the ability to put pressure more so on the non-investment grade rated firms. In addition, the Watchlist has empowered rating agencies to provide information that is not only timely, accurate, and stable but also of a different quality. Hence, the authors conclude that the Watchlist instrument has indeed enhanced the role of credit rating agencies in the market.