Are Credit Rating Announcements Contagious?
Evidence on the Transmission of Information across Industries in Credit Default Swap Markets

Abstract

The aim of this article is to empirically test for the presence of intra-industry informational transfers (IIIT) induced by rating signals in the markets for corporate credit risk. In particular, the author studies the intra-industry credit default swap (CDS) spread responses to credit rating announcements made by Standard & Poor’s (S&P), Moody’s Investors Service, and Fitch Ratings between January 2003 and March 2011. He finds statistically and economically significant industry spread responses to the announcements made by S&P and only marginally significant and insignificant industry spread responses to the rating signals of Moody’s and Fitch, respectively. This suggests that S&P announcements contain the largest component of industrywide information.

In the case of S&P, the author observes strong evidence in favor of contagious IIIT, implying that on the day of an announcement, industry abnormal spreads tend to move in the same direction as event-firm spreads. This finding holds across all four types of rating events, in particular for cases in which the event-firm spread reaction has its predicted sign (positive [negative] spread change in the case of negative [positive] rating news). The magnitude of industry peer reaction (to S&P announcements) is found to be about 6% of the event-firm abnormal spread change. Stratification and multivariate regression analyses reveal a rich pattern of IIIT behavior across several event-firm, event, and industry characteristics.

For negative rating events, contagious IIIT effects tend to be stronger when event companies (a) are relatively large (only in the case of downgrades), (b) come from industries with large industry peers, (c) have a high degree of cash-flow similarity with their industry peers, (d) are highly leveraged, (e) have higher than industry-average credit rating before the event, and (f) come from relatively creditworthy industries. For positive rating events, the contagious IIIT effects tend to increase with (a) industry-peer cash-flow similarity, and (b) degree of financial distress, characterized by below-average event-firm credit quality and low average industry credit quality. These results contribute to the understanding of credit risk correlations and are consistent with recent theoretical models of credit risk correlations of Giesecke [2004] and Collin-Dufresne et al. [2010a].