The roles of rating outlooks: the predictor of creditworthiness and the monitor of recovery efforts

Abstract

Using a comprehensive U.S. rating sample from S&P's between 1981 and 2015, we examine the information content, responsiveness to credit risk and recovery effort associated with rating outlooks. We find that rating outlooks (and credit watches) have important information contents and are significantly associated with credit worthiness, measured by expected default frequency. More importantly, we show that by assigning negative outlooks, credit rating agencies induce some issuers to exert recovery efforts to prevent subsequent downgrades. The finding supports the theoretical prediction of Boot et al. (2006) that credit rating actions serve as a coordination mechanism between rating agencies and issuers.

Market‐implied ratings and their divergence from credit ratings

“…We find that ROA decreases more and default probabilities increase more in firms with negative signal and subsequent downgrade, suggesting that some firms may ignore the warning signals from MIRs or they are not able to exert recovery efforts to improve their financial performance, thereby receiving downgrades afterward. Our results are similar to the findings in Poon and Shen (2020). Results are not reported to save space but are available upon request from the authors.…”

“…The DID test shows that the treatment group has greater ROA and lower short-term debt and default probability during the postsignal period than does the control group. The analysis indicates that even though MIRs can provide leading information, some issuers are not willing or have no ability to conduct sufficient recovery efforts and hence are subsequently downgraded, similar to the findings in Poon and Shen (2020) for their analysis of negative outlook status. Results are not reported to save space but are available upon request from the authors.…”

“…However, given that the time on the credit watch list is short, that is, 90 days, it may be difficult for some firms to exert meaningful recovery efforts to avoid downgrades. Poon and Shen (2020) believe that negative outlooks may induce firms to take remedial actions, however, because negative outlooks also indicate potential downgrades and the outlook period can last up to 2 years, which is considerably longer than a credit watch.…”

“…Including those firms would make it harder to uncover the potential positive impact of MIR signals. Following Poon and Shen (2020), we also compare the changes in the financial ratios and default probabilities in the group of firms that receive MIRs warning signals and are downgraded in the subsequent 4 quarters and in the group of firms without such signals and with subsequent downgrade. We find that ROA decreases more and default probabilities increase more in firms with negative signal and subsequent downgrade, suggesting that some firms may ignore the warning signals from MIRs or they are not able to exert recovery efforts to improve their financial performance, thereby receiving downgrades afterward.…”

Price, Volatility and the Second-Order Economic Theory

“…However, numerical credit scoring was suggested eighty years ago by Durand (1941) and sixty years ago by Myers and Forgy (1963). Last years researchers use numerical risk rating to compare risk assessment provided by different rating agencies (Beaver et.al., 2006;Poon and Shen, 2020). We assume that no internal econometric problems prevent the transfer from letters to numerical risk scoring.…”