Pre-downgrade credit watch placement and post-downgrade long-term stock performance

What is it about?

Among firms that receive rating downgrades, those once placed on raters' watch list significantly outperform those that are not. The study presents evidence that a credit watch placement is not only an early warning of a possible rating downgrade but also informative about a bond issuer's ability to recover from credit deterioration. Compared with firms that are directly downgraded, firms receiving watch-preceded downgrades show better improvements in operating profitability, financial leverage, and overall default risk, long-term stock performance, and are less likely to be further downgraded in future periods.

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Why is it important?

The study suggests that credit watch placement can be related to remediation of credit deterioration. It shows that the perform implications can be economically significant. A zero-investment portfolio that is long on downgraded firms preceded by watch placements and short on direct-downgrade firms shows a monthly alpha of 0.7-1%.

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