Market‐implied ratings and their divergence from credit ratings

Iftekhar HASAN, Jianfu SHEN, Gaiyan ZHANG*, Winnie P. H. POON

*Corresponding author for this work

Research output: Journal PublicationsJournal Article (refereed)peer-review

Abstract

In this article, we investigate the divergence between credit ratings (CRs) and Moody's market-implied ratings (MIRs). Our evidence shows that rating gaps provide incremental information to the market regarding issuers' default risk over CRs alone in the short horizon and outperform CRs over extended horizons. The predictive ability of rating gaps is greater for more opaque and volatile issuers. Such predictability was more pronounced during the 2008 financial crisis but weakened in the post–Dodd–Frank Act period. This finding is consistent with credit rating agencies' efforts to improve their performance when facing regulatory pressure. Moreover, our analysis identifies rating-gap signals that do (do not) lead to subsequent Moody's actions to place issuers on negative outlook and watchlists. We find that negative signals from MIR gaps have a real economic impact on issuers' fundamentals such as profitability, leverage, investment, and default risk, thus supporting the recovery-efforts hypothesis.
Original languageEnglish
Pages (from-to)251-289
Number of pages39
JournalJournal of Financial Research
Volume46
Issue number2
Early online date12 Apr 2023
DOIs
Publication statusPublished - Jul 2023

Bibliographical note

Funding Information:
We thank two anonymous referees and the editor for their valuable comments and suggestions, which greatly improved our paper. We acknowledge the research grant from the General Research Fund (GRF), Research Grants Council, Hong Kong (LU13501214). We thank Cheung Chun‐Kit for his excellent research assistance. All errors remain our own.

Publisher Copyright:
© 2023 The Southern Finance Association and the Southwestern Finance Association.

Cite this